Google's announcement on Tuesday comes amid growing tensions between China and the United States over Internet freedoms, with U.S. Secretary of State Hillary Clinton set to announce a technology policy next week to help citizens around the world have access to an uncensored Web.
China has over 350 million Web surfers and annual search revenue topping $1 billion.
Despite its allure, anyone doing business there must adhere to strict Chinese censorship rules that ban discussion or display of pages on sensitive topics ranging from Tibetan independence to the banned Falun Gong spiritual movement.
Companies like Google and Microsoft, along with domestic giants Baidu and Sina, all adhere to such rules, though none likes to speak publicly about them.
In its latest China roadbump, Google said it had uncovered a sophisticated attack on the email accounts of Chinese human rights activists using its Gmail service, and that more than 20 other companies were similarly attacked.
These attacks and the surveillance they have uncovered -- combined with attempts over the past year to further limit free speech on the Web -- have led us to conclude that we should review the feasibility of our business operations in China, Google Chief Legal Officer David Drummond said in a statement.
We recognize that this may well mean having to shut down Google.cn, and potentially our offices in China.
China is one of the few markets where Google is not in the lead, lagging Baidu which commands a 60 percent share of the Chinese Internet search market versus Google's 30 percent.
Shares of Google fell 1.3 percent in after-hours trading after the news that it might withdraw from China, while Baidu shares jumped 6.8 percent. Sina shares gained 1.3 percent.
This is definitely a big surprise and very sad news for users in China because now we have fewer choices, said Edward Yu, chief executive of Beijing-based research firm Analysys.
Emotionally speaking, this is negative for foreign players trying to develop in the Chinese market, but from a rational point of view, it is still to be seen whether Google pulls out.
AT ODDS WITH THE WEST
China's tough stance on Web censorship has put it at odds with Western technology firms in recent years.
The latest dispute had pit personal computer makers against a Chinese government intent on keeping pornography out of the hands of China's youth, though many believe the move involved censorship and invasion of privacy.
In June, Beijing ordered Google to block overseas sites with vulgar content from being accessible through the Chinese language version of its search engine. Google said then that it met with Chinese government officials and was taking necessary steps to ensure search results on its Chinese site complied.
Google said the hackers in the recent attack had tried to break into Gmail accounts of Chinese human rights activists, but only managed to access two unidentified accounts, and could only see subject headings and other data such as when the account was created.
It did not say what information the hackers tried to access from other companies, nor which they were. Google said it was now notifying the other affected corporations, adding it was working with the U.S. authorities.
A Google spokesperson said the company was still investigating the attack and would not say whether Google believed Chinese authorities were involved.
Microsoft, whose rival Hotmail e-mail service is also available in China, said it had no indication that any of its mail properties had been compromised in China.
The attack on Google was disclosed a day after Baidu's site was hacked briefly by people calling themselves the Iranian Cyber Army.
The Google attack implies that the government may somehow be responsible, said RBC Capital Markets analyst Stephen Ju.
This is a complete 180 (degree) turnaround (for Google). Just about every earnings call recently has been that they are focused on the long-term growth opportunities for China and that they are committed.
Google generated 53 percent of its $5.9 billion in revenue in the third quarter outside the United States. It does not disclose the size of its business in China.
Many of Google's primary services, such as Gmail and Google.com, became briefly inaccessible to many Chinese users last year, and its YouTube video site has been inaccessible there since March.
We have decided we are no longer willing to continue censoring our results on Google.cn, and so over the next few weeks we will be discussing with the Chinese government the basis on which we could operate an unfiltered search engine within the law, if at all, Drummond said.
Human rights have been a frequent source of tension between the United States and China, which is the largest holder of U.S. Treasuries, with total holdings of $798.9 billion.
Last week, Clinton dined with tech heavyweights such as Google CEO Eric Schmidt, Twitter co-founder Jack Dorsey, Microsoft research and strategy chief Craig Mundie, and Cisco Systems Inc Executive Vice President Sue Bostrom.
It was not clear if the meeting was related to Google's revelation, and the companies had no immediate comment.
According to JPMorgan, China's search market hit $1 billion in 2009 and will grow to $1.5 billion this year. But search advertising is still less than 50 percent of the total online ad market in China, compared with 67 percent in the United States.
What makes Google the largest search engine and one of the leading Internet companies is that they care about users' privacy, and if that privacy comes under challenge it may impact their global business, said Collins Stewart analyst Sandeep Aggarwal.
They obviously did not appreciate the attack ... We should not take the Google threat lightly.
(Additional reporting by Doug Young in HONG KONG, Edwin Chan in LOS ANGELES and Jim Finkle in BOSTON; Editing by Peter Henderson, Steve Orlofsky and Ian Geoghegan)