(FORTUNE Magazine) – Just when the ongoing feud between Microsoft and Sun Microsystems seemed to have died down, Sun CEO Scott McNealy decided to lob a grenade: He announced that Sun will produce a free, Web-based suite of spreadsheet and word-processing applications to compete with Microsoft Office. McNealy's dream is an old one: WordPerfect, Lotus, Corel, Borland, Novell, and IBM all tried at some point to lop off a slice of the lucrative suite market, which accounts for as much as 40% of Microsoft's sales. They all failed.

By cracking Microsoft's virtual monopoly in office suites, Sun would show the world that productivity applications could run on something other than the typical PC with Microsoft Windows and Office--that they could instead run on something as simple as a thin client computer made by, say, Sun.

McNealy thinks he can succeed because the rules of the game may have changed. Scores of companies have figured out ways to offer free e-mail, chat, and scheduling programs through your browser. Now Sun wants to do the same for word processors and spreadsheets. It won't be easy: Corel tried rewriting its productivity suite in Sun's Java programming language for deployment on the Web but pulled the plug before the project was finished. Lotus' eSuite made it to market, but on Sept. 9, IBM said it will halt further marketing of the product.

Sun's moves renewed the industry debate on the shift from packaged, shrink-wrapped software to software in the form of Web-deployed "services." The question is whether, like phone or cable TV service, software may eventually be rented or bought via a subscription paid to your Internet service provider (ISP). The appeal for developers is obvious: Microsoft has long desired to move from depending on occasional purchases of shrink-wrapped software to a steady stream of subscription fees. Businesses pay annual licensing fees already; if Web-based applications take off, consumers might do the same.

The appeal for consumers is less certain. Business travelers might very well like being able to gain access to their applications and data via any Web-connected browser on any computer. But no one knows whether people accustomed to having all their productivity software on their own PC's hard drive will be comfortable relying on something stored on the Web. Big issues--including security and reliability--have yet to be resolved.

Such worries haven't held back Sun, which in August acquired Star Division, a Fremont, Calif., software developer whose StarOffice productivity suite works with the Windows, Linux, Solaris, and OS/2 operating systems. Star is crafting a version of the suite, called StarPortal, for the Web. It says StarPortal applications will run in your Web browser, so just as you can access Web-based e-mail from any browser--on your laptop, in an airport kiosk, on your PC at work--you'll be able to write a letter or draft a presentation. The software will even let you edit Word documents. "Say you forgot your laptop or don't want to take it on the road," says George Paolini, vice president of corporate marketing for Sun. "You will be able to access your desktop in the complete state you left it, with your applications, your documents, your changes."

Web-based productivity software is generating interest among ISPs. Says Veronica Murdock, EarthLink's vice president of member support and services: "If Sun can make [StarPortal] efficient enough, it could be quite a substantial win for them." But in recent weeks, security and reliability problems have plagued service providers like Excite@Home and Microsoft's Hotmail. Needless to say, if such problems hit Sun, Murdock would be less interested.

Paul Rheaume, who manages the computer systems for Dishes Delmar, a San Francisco purveyor of vintage dishes and pottery, is exactly the kind of tech-savvy customer Sun must win for its Star suite to succeed. But he doesn't trust even Web-based e-mail, let alone a Web-based word processor. "There's no way I'd use a word processor or anything important via the Web until the stability and security of ISPs and such improves," he says.

Then there's the problem of customer support. When your free e-mail goes down, there's often no one to call. But customer service could turn out to be a plus for Sun as it takes on Microsoft. According to Rob Enderle, a vice president of Giga Information Group, a market-research firm in Santa Clara, "Microsoft is enjoying the highest levels of customer dissatisfaction of any company we've monitored--ever. There's an opportunity for someone to move in and cause their market share to decline."

Another challenger, Desktop.com, is launching what it calls a Web desktop that would give you access through a browser to all your applications and files, whether they reside on your PC or on a Web server. The ambitious San Francisco startup has raised $29 million in venture funding; CEO Katie Burke is trying to attract developers to write simple Web-based apps that the company will host.

All the excitement about Web-based apps may be moot if Microsoft fights back as successfully as it has in the past. A few days after Sun announced StarPortal, Microsoft unveiled a plan to keep developers in its camp by letting them "program the Web." But it stopped short of a promise to move its applications to the Web. George Meng, group product manager for Microsoft Office, says his Web-hosting plans--whatever they are--weren't prompted by Sun's moves. He insists that Web-hosted applications will complement rather than replace shrink-wrapped ones. "It's not a transition," he says. "It's adding a new offering to the mix."

That raises what might be the most interesting question about this trend: Will Microsoft have to cannibalize its mainstay application, Office? The company has sold more than 100 million copies of Office, which carries a retail price as high as $600. Designing a Web-based alternative seems a risky way to fight Sun. But given Microsoft's history with Internet scraps--remember Netscape?--it may not be all that risky.

--Jodi Mardesich