(FORTUNE Magazine) – As if Kodak's George Fisher didn't have enough problems. Over the past few weeks, his earnings tanked, his stock self-destructed, and he has been forced to announce layoffs numbering in the thousands. Now to top it all, his biggest competitor, a lean, hungry company called Fuji Photo Film Co., is making an aggressive, and successful, grab for market share in Kodak's own backyard.

For some years now Fuji and Kodak have been battling it out in overseas film markets. But in the U.S. the picture was quite different. Kodak and Fuji treated that market like a cozy, mutually profitable duopoly. Both enjoyed fat margins. Kodak controlled over 80% of the American film market, and distant No. 2 Fuji always priced its film just a little bit lower.

Then last spring Fuji began slashing prices by as much as 25%. Fuji's explanation is that Costco, one of its five largest distributors in the U.S., ditched Fuji for Kodak, and the company got stuck with 2.5 million rolls of film. Fuji unloaded the film at a steep discount to other distributors. When consumers saw that the familiar red, white and green boxes were a buck or two cheaper, they snapped them up. Over the past year Fuji increased its share of the U.S. film market to nearly 16% from 10%, while Kodak's share took an unprecedented tumble from 80% to just under 75%.

Fuji executives deny that they intended to start a price war: "We did nothing special," says Yasuo "George" Tanaka, executive vice president of Fuji's U.S. subsidiary. "We're just getting customers one frame and one picture at a time." Fine, but if Fuji isn't waging a price war, why are its prices still hanging low now that the excess inventory has been worked off? Whatever the case, for the first time in its 113-year history, Kodak can no longer take its home market for granted.

It may be tempting to think that Kodak shouldn't sweat it. The Rochester, N.Y., company still overwhelmingly dominates the $2.7 billion U.S. amateur film market. The Kodak brand remains solid gold, and its quality is not in dispute. But Fuji's gains in the U.S. are ominous, especially because the Japanese film company is already poised to surpass Kodak on a global basis, particularly in Asia, where film sales are growing at 20% a year or more. (Worldwide, Fuji and Kodak are neck and neck, with about a third of the market each.) Alex Henderson, managing director of technology research at Prudential Securities Inc. in New York, who has been watching the two companies for 12 years, believes that if current trends hold, Fuji will overtake Kodak next year. "When that happens," says Henderson, "Kodak will go from being Coke to being Pepsi. That's a very damning thing." Worse yet, he expects that in the U.S., Fuji will continue to creep up on Kodak by a rate of about 2% a year.

What should be equally troubling to Fisher is that Fuji's financial strength gives it more flexibility to cut prices. Fuji's sales last year were a record $11 billion, and profits were a near-record $757 million; at the same time, Fuji has a net cash position of about $4.5 billion and access to incredibly cheap borrowing--around 2.5%--thanks to Japan's record-low interest rates. Kodak has more than $1 billion in short- and long-term debt and is in the midst of a sales and profit slide, not to mention impending restructuring write-offs likely to run to $1 billion or more. And Kodak can't borrow at much under 7%. Fuji can afford a showdown, but can Kodak?

The two giants are slugging it out for three equally important parts of the consumer photo business. Those little yellow and green film boxes are the most obvious part to the man in the street, but Fuji and Kodak also manufacture photographic paper, mostly for sale to big photo-processing laboratories and small retail developers. To ensure a market for their paper, both companies have invested heavily in the third line of business--developing--by buying up big film-processing companies across the U.S. Fuji's deep pockets have enabled it to make acquisitions like the estimated $400 million purchase last year of Wal-Mart's six wholesale photo labs, a move that in one swoop gave it about 15% of the U.S. photo-processing market.

Fuji's long-term strategy is to transplant as much film and paper production as possible onto U.S. soil. That keeps costs down, reduces nettlesome trade disputes, and makes Fuji's factories more responsive to local market demands. In 1987, just 3.5% of Fuji's production was outside Japan; now the figure is 31%, and the move offshore is accelerating. Last April Fuji opened a highly automated, $300 million photographic paper plant in Greenwood, S.C., which is already producing about 20% of the photo paper consumed in North America. Later this year Fuji will open an equally high-tech, $200 million film plant in Greenwood. According to Tanaka, it would not take much time or investment to double the plants' capacities should Fuji need it. Take a deep breath, Mr. Fisher.

Fuji is one of the leanest and meanest of Japan's big companies. Led for the past 17 years by no-nonsense Chairman and CEO Minoru Ohnishi, Fuji was cutting white-collar overhead long before it started to become fashionable in Japan. In the past ten years the company's sales nearly doubled worldwide, but its staffing in Japan remained almost flat. Ohnishi tries to maintain a sense of crisis by reminding staff that Kodak is still out front. "He likes to constantly cut costs in order to anticipate a rainy day," says Tanaka, "so that there will be less pain down the road." Or more likely, greater market share.

Fuji's aggressive tactics have sometimes earned it charges of unfair trading practices. In the early 1990s the U.S. Commerce Department investigated charges that the Japanese company dumped photographic paper in the U.S. market. Fuji managed to dodge import duties by agreeing to raise prices to levels just above the going rate. (Fuji subsequently lost most of its 20% market share but bounced back when it opened its paper plant in Greenwood and bought out Wal-Mart's processing labs.) And the World Trade Organization is expected to rule soon on U.S. allegations that the government of Japan worked with Fuji to exclude competitors from the Japanese market, which Fuji dominates with a 70% market share. A decision is expected this year, though it's unlikely to affect either company's business.

Ironically, Fuji got its big break in the American market thanks to Kodak. The company opened its first office in the U.S. in 1958, in the Empire State Building, but it only began selling film there in 1970, when it was one of several relative minnow--among the others were GAF, Agfa, and 3M--swimming in Kodak's pond. Then in 1984 the Olympics came to Los Angeles. Olympic czar Peter Ueberroth believed that Kodak was the natural choice to be the exclusive film sponsor, but Kodak wouldn't bite. Even after Ueberroth visited Rochester to make his pitch, Kodak refused to pay just $1 million, far below the $4 million floor for sponsorships that Ueberroth had established. So he approached Fuji, which in those days was still barely known in the U.S. market. Ohnishi said yes on the spot and eventually committed around $7 million. No marketing investment ever brought better returns. Within months of becoming a sponsor, Fuji landed 50,000 new distribution outlets. "Salespeople said that accounts that didn't used to return their calls were suddenly calling them," says Tom Shay, head of corporate communications for Fuji USA and a 26-year Fuji veteran. "The Olympics completely changed the way people looked at us."

Since then, Fuji has built a reputation for price, quality, and sharp marketing. It has won a strong following among professional photographers, some of whom rave over the film's luminous blues and greens. Its acceptance in the professional world has given Fuji a lot of cachet with amateur shutterbugs. Fuji also adopted a hipper, more technologically oriented marketing image to differentiate itself from a Kodak style that was sentimental, if not syrupy (at least until Fisher began jazzing it up). In 1993, Fuji ran a highly successful, award-winning TV campaign obliquely directed at Kodak. The killer line: "Pictures should be nostalgic; your film shouldn't." Fuji's current slogan also paints the company as forward looking: "You can see the future from here."

In technology too, Fuji has shown that it can set the pace by consistently spending about 7% of sales on R&D. In 1986 Fuji was the first to introduce the disposable camera, a product that has been a huge boon for both Kodak and Fuji. Fuji also worked with Kodak and other companies to introduce a new 24mm "advanced photo system" film--which uses a new generation camera, a hybrid of digital and traditional systems. In Japan the launch was a great success, thanks to Fuji's ensuring that the cameras and processing were readily available. APS already accounts for about 10% of the color-negative film market in Japan. "Fuji's greatest strength is that they always make sure that consumers are ready to buy their new products, and they actually get the products to the consumers," says Toby Williams, an analyst at SBC Warburg in Tokyo. By contrast, Kodak flubbed the U.S. introduction of its advanced photo system, called Advantix.

If Kodak and Fuji have one thing in common, it's their vulnerability as photography moves into the digital age. This year alone, market watchers expect to see 1.8 million digital cameras sold worldwide, and that number will grow sharply as quality improves and prices drop. That poses three big issues for film companies: One is the danger--still much in dispute--that film sales will soften as digital cameras made by companies like Sony, Canon, and Casio take up a bigger share of the market. Another is a challenge on the photographic paper and processing side from Canon, Epson, and Hewlett-Packard. Their latest generation ink-jet printers produce high-quality prints of digital images on plain and coated paper. (Fuji just launched one of its own.) Both Kodak and Fuji are working on ways to add value to digital photography--such as a service that lets customers order prints directly over the Internet--but those ideas are untested.

Finally, Kodak and Fuji have jumped into the digital camera business themselves. But they are in a mob of nearly two dozen camera, computer, and consumer electronics companies trying to get into the same space. One thing is sure: The companies that win in digital photography will need marketing and product smarts, technology and, not least, money. Fuji, it seems, has them all.

REPORTER ASSOCIATE Jeremy Kahn