(FORTUNE Magazine) – Microsoft, freshly recertified as a monopolist by the U.S. Court of Appeals, calls its next-generation Windows XP operating system software the company's most important product launch since Windows 95. Why? Windows XP is not just another improved version of Windows, which controls more than 90% of the world's desktop computers. It is also the unveiling of Microsoft's emerging .Net Internet-era business plan, which has the company moving from its historical reliance on one-time software licenses toward a business model based on recurring subscription and transaction fees for software and services.

Put another way, Microsoft envisions .Net--with XP as its initial platform--as the new operating system for the Internet. And being Microsoft, it hopes to dominate the Internet just as it has dominated the markets for desktop computers, office productivity software, and Internet browsing software. For companies with similar designs--notably America Online--that means war.

Windows XP, due to be released Oct. 25, bristles with small software triggers and hooks that can link users to a variety of online services, including, of course, services offered by Microsoft. As has been its practice, Microsoft is promoting the new services by bundling them into its ubiquitous operating system.

Want to get a stock quote? XP will happily take you to a Microsoft-run financial service. Buy a book? With a Microsoft Passport account, a fundamental component of XP, your identity, financial account, and credit card information is already stored online, ready to enable instant e-commerce. Print a digital picture? XP provides automatic links to services that pay Microsoft for the linkage. Download a new song? Microsoft will send you to its proprietary Windows Media Player--and take a cut of the transaction fee. Importantly, XP will also feature Microsoft's instant-messaging service and enable voice calls over the Internet. And it will give consumers their first taste of Microsoft's forthcoming Web-centric transaction architecture, called Hailstorm, which will allow the delivery of all of the above--and a lot more--over the Internet anytime, anyplace, on any Web-enabled device.

Inevitably, the arrival of Windows XP will take the historical competition between Microsoft and AOL to a new level. In the past, while AOL competed with MSN, the Microsoft Network--and testified against Microsoft during the antitrust trial--it was also an important, if wary, strategic partner. AOL featured Microsoft's Internet Explorer browser in its own service in return for the placement of AOL's software on the main screen of Windows. But now AOL is competing with elements of the operating system itself. That helps explain why contract talks to continue this agreement with XP and the forthcoming AOL 7.0 broke down last month.

In some ways this growing competition was inevitable; indeed, FORTUNE predicted it at the time of AOL's proposed merger with Time Warner. (See "The Men Who Would Be King," in the fortune.com archive.) Although they come from significantly different starting points--AOL is a consumer-marketing company that happens to use technology; Microsoft is a technology company that happens to use consumer marketing--the two rivals each envision a day when consumers will use their services throughout the day for communications, information, entertainment, electronic commerce, and business services. Though many of these services are free today, they will eventually cost money. The company that captures those dollars will be the one that offers consumers the best value in terms of ease of use and richness of services. Microsoft and AOL both want to be that company.

It is impossible, of course, to know how this competition will play out. In the consumer market, AOL has the edge right now. After all, its 30 million customers are a potent force, and Microsoft can't afford to alienate them by, say, making it difficult for AOL users to access the service via Windows. Also, AOL has cut its own deals with major computer manufacturers for desktop placement--agreements that can't be nixed by Microsoft. If it did nothing else, the lawsuit weakened Microsoft's ability to dictate terms to computer makers.

But you can never count Microsoft out. For one thing, unlike AOL, Microsoft has no debt and $30 billion in the bank. Besides, Microsoft has a long history of adding features to Windows that compete directly, and sometimes lethally, against smaller companies. The most obvious example is Netscape, whose Web browser once owned 90% of the market--and is now an insignificant force in the marketplace. It has been replaced, of course, by Internet Explorer, which is part of Windows.

With XP, Microsoft has extended this strategy to a whole host of products, involving a range of competitors. New features in XP include firewall software for protection against hackers (competing against Symantec, Network Ice, and Zone Labs), media player software with CD burning and DVD playback (Apple, Roxio, RealNetworks, Intervideo, Ulead), remote access tools (Netopoia), and photo editing (Adobe, Corel, MGI).

Still, the biggest battleground is likely to be over instant messaging and notification, services that allow users to send and receive, without delays, short text messages, images, and even voice "calls" that travel over the Internet when two or more people are connected at the same time. AOL dominates instant messaging today; at peak times, several million AOL customers--mostly teenagers--are sending instant messages simultaneously. Some analysts predict that instant messaging will be even more popular in business, where Microsoft is traditionally strong--and where AOL Time Warner hopes to make inroads. Microsoft has had instant messaging for some time through its MSN service, but with XP it combines a number of improvements into the operating system itself, including video teleconferencing.

The key to instant messaging and notification is to verify the identity of the user, which Microsoft hopes to do through its Passport feature in XP. But critics (see Stewart Alsop's "The Monopoly Has Just Begun," in this issue) say that by requiring XP users to register for Passport, Microsoft could effectively lock users into its system for years to come. AOL, meanwhile, has limited the use of its AIM instant messaging service to AOL subscribers, arguing that opening its system to outside systems like those of Microsoft and Yahoo would put AOL customers at risk of encountering unsolicited mail and advertisements (spam), pornography, and sexual predators from the "outside." Such evils, of course, are already hardly unknown to AOL users.

What's more, for all the criticism Microsoft has endured for using XP to steer consumers to its other services and products, one could hurl the very same charge at AOL. Its traditional strategy has been to contain its 30 million customers largely within the confines of its service while using proprietary technologies to block outsiders. Of course, it does offer users easy access to content and services either controlled by or linked by contract to AOL Time Warner.

Perhaps that's why AOL has been strangely quiet in the recent controversy over Passport. AOL, it turns out, has something similar in the works.