Microsoft will not pay an upfront fee to Yahoo, and the focus of the deal is on sharing revenue between the two companies, said the source, who did not want to be identified because a formal announcement has not been made.
The news and details of the expected deal were first reported by the AllThingsDigital blog and Advertising Age.
Microsoft and Yahoo declined comment. The two companies have talked for months about cooperating in the online advertising market, dominated by Google.
Microsoft tried to buy Yahoo last year but its $47.5 billion bid was rebuffed and Yahoo's attempt to seal a search advertising deal with Google Inc fell apart under regulatory scrutiny.
Under the expected deal, Microsoft's new Bing search engine will power Yahoo's searches, according to Advertising Age, while Yahoo will handle the advertising sales, using Microsoft technology.
The deal should give Bing a giant boost in competing with Google's search engine. Google's search engine dominates the marketplace with 65 percent of U.S. Internet searches, according to figures provided by research firm ComScore. Last month, Microsoft had only 8.4 percent of the market and Yahoo 19.6 percent.
There is a chance a deal combining the powers of the second and third-ranked search engine companies would be blocked by antitrust regulators. Google and Yahoo dropped plans for an advertising partnership last year under opposition from the U.S. Department of Justice.
The deal may also face privacy issues, said Colin Gillis, an analyst at Brigantine Advisors.
Any agreement where Microsoft powers search and shares the search data to Yahoo is open to scrutiny from US and EU justice departments, said Gillis.
That could trigger federal regulation limiting the ability of companies like Yahoo to collect data from users' searches and share it with partners, said Gillis, which would remove a key advantage of the partnership.
Shareholders of both Microsoft and Yahoo have been urging the two to strike a deal for some time. Earlier this month, activist investor Carl Icahn, who owns about 5 percent of Yahoo and is a director on its board, spoke out in favor of a search deal, as talks between the two companies appeared to regain momentum.
Shares of Yahoo traded at $17.39 in after-hours trading after closing at $17.22, while shares of Microsoft rose to $23.51 in after-hours trading from their close of $23.47.
(Reporting by Bill Rigby and Alexei Oreskovic, writing by Tiffany Wu; Editing by Steve Orlofsky, Carol Bishopric and Bernard Orr)