(FORTUNE Magazine) – In April 1999, Procter & Gamble Chairman John Pepper gave the key-note address at a meeting in Montreal of the Society of Competitive Intelligence Professionals, a trade association for, well, corporate spies. "I can't imagine a more appropriate time to be talking about competitive intelligence [industry jargon for spying] than right now," Pepper began. "For I can't imagine a time in history when the competencies, the skills, and the knowledge of the men and women in competitive intelligence are more needed and more relevant to a company."

Little did Pepper realize how ironic his words would soon sound. Two years later, in the early spring of this year, he was informed of a major spying campaign undertaken by his own company that had spun wildly out of control. Corporate spying is something of a growth industry these days (see "The Prying Game" in this issue), and P&G has long engaged in what it calls "competitive analysis," but after hearing the details of this particular operation, Pepper was apparently shocked. P&G immediately stopped the campaign and fired three managers responsible for hiring the corporate spies. And then it did something almost unheard of in corporate America: It blew the whistle on itself. P&G fessed up to the primary target of the operation, Anglo-Dutch giant Unilever. At press time the two consumer products giants were discussing terms of a settlement.

What exactly did P&G do? We don't know all the details yet (FORTUNE first revealed the spy operation on the fortune.com Website on Aug. 30), but here's what we know as of our deadline. Competitive-analysis executives at P&G hired a general contractor, who in turn hired perhaps as many as a dozen subcontractors to spy on its competitors in the hair-care business--particularly Unilever, but other companies as well. The operation was run out of a safe house, called the "Ranch," which sources say was in P&G's hometown of Cincinnati. At least one of the competitive-intelligence firms hired by P&G engaged in dumpster diving in an attempt to gain information from Unilever. A source says that in their dumpster-diving pursuits, these operatives trespassed at Unilever's hair-care headquarters, an office building at 325 North Wells in Chicago. The source also says that these corporate spies, whom P&G now describes as rogue operators, misrepresented themselves to Unilever employees, suggesting they were market analysts or maybe even journalists, God forbid, in an attempt to gather information. (P&G confirms the dumpster diving, but it denies that misrepresentation took place.)

The dirty tricks were intended to glean competitive data on Unilever's hair-care products--which include Salon Selectives, Finesse, Thermasilk, and Helene Curtis--in order to bolster P&G's own brands, which include Pantene, Head & Shoulders, and Pert. Apparently the operation was a big success: P&G got its mitts on just about every iota of info there was to be had about Unilever's brands. New-product rollouts. (Top-secret lemon-scented Finesse, anyone?) Selling prices. Margins. You name it. And while P&G insists that the company broke no laws, a spokeswoman says that activities undertaken by its hired operatives "violated our strict guidelines regarding our business policies."

P&G informed Unilever about the transgressions in April, and the two companies have been trying to negotiate a settlement ever since. At our deadline, a settlement was within reach. According to someone close to the negotiations, the following points were being hashed out: (1) P&G would reassign several key personnel in its hair-care business to other positions in the company (hello, Pringles!). (2) P&G would be restricted in its market activity in the hair-care business. Meaning, for instance, it could not launch certain new products until the end of 2003. (3) An independent, third-party investigator would be appointed to review P&G's entire business plan in this area and would report back to Unilever to ensure that any trade secrets stolen from Unilever would not be used. (4) P&G would pay Unilever tens of millions in cash. (If no settlement is reached, of course, Unilever could decide to take P&G to court.)

Sounds pretty onerous, doesn't it? Does that mean P&G's campaign was so full of dirty tricks that it has no choice but to simply roll over? Perhaps, but it could also be that Pepper is in full "do the right thing" mode--that he's trying to take a page out of Johnson & Johnson's forthright handling of the Tylenol case, particularly since P&G has a long history of playing the hardest of competitive hardball. If P&G thought it would receive any special dispensation from Unilever by telling on itself, though, the boys from Cincinnati have been sorely mistaken. "It was like confessing to murder and hoping to get manslaughter instead of homicide," says one source close to the story. "It just doesn't always work out that way."

A source says the spying against Unilever and other competitors began last fall and continued into this year. The operation was halted in March or April only after senior P&G officials, including Pepper, learned about it. Procter & Gamble confirms that it fired three P&G employees "who were directly involved in the project." Susan Steinhardt, formerly P&G's director of corporate competitive analysis, acknowledged that she recently left the company but declined to say whether she was one of the three who were fired. (At the 1999 spy conference in Montreal, Steinhardt did a Q&A with Pepper. It can be read at www.scip.org/news/cimagazine_article.asp?id=215.)

After Pepper and senior managers discovered the spying operation, P&G executives wrote a letter to Unilever outlining the transgressions. Pepper himself called Unilever Co-Chairman Niall FitzGerald in an effort to settle the matter.

Sources say that one of the subcontractors that investigated Unilever was Phoenix Consulting Group of Huntsville, Ala. Phoenix was founded and is staffed by former government intelligence officers. Its president, John A. Nolan III, says that he and others in his company served in the Phoenix Program, a covert operation in Vietnam. When asked whether he was hired by P&G, did any work on behalf of P&G, or had any connection to this operation, Nolan declined to comment.

While corporate spying is not unusual, informing the target of the spying is. Over the past five months, P&G has invited Unilever officials to interview P&G managers as well as the operatives themselves. But one source says that Unilever has been unhappy about the level of P&G's cooperation, and that is why the negotiations have dragged on so long. The source adds that P&G at first provided Unilever with two documents regarding its spying activities and then, after further prodding, came up with over 50 additional documents.

Unilever has completed its review only within the past few days. On Tuesday, Aug. 28, a source says, P&G's Pepper flew to London with an offer to settle the matter. At that point a deadline was set for the close of business Friday, Aug. 31, but no settlement was reached, and the deadline was pushed back to Tuesday, Sept. 4.

"None of the information that was gathered in this operation was ever used by P&G or will ever be used," a P&G spokeswoman said. "It was an unfortunate situation. We certainly regret that it occurred. We have acted responsibly and promptly to protect Unilever's interests."

Of course, all this leaves unanswered one burning question: What kind of shampoo should a person use after an evening of dumpster diving?