(FORTUNE Magazine) – To the big record labels, Napster wasn't just a nuisance; it was their worst nightmare--the online equivalent to everyone storming into record stores and making off with armfuls of CDs. So when an appeals court issued an order last July forcing Napster to shut down, there was a sigh of relief throughout the recording industry. It was the day free music died.

Or so it seemed. Napster as we knew it is gone. But what's taken its place is a lot scarier for the music industry--and perhaps unstoppable. They're called file-sharing services, or P2P networks in geek-speak, and the three most popular ones--Kazaa, Grokster, and Morpheus--have a combined 70 million active users, compared with only 20 million for Napster in its heyday. Oh, and it's not just music being zapped across the Internet anymore. The new Napsters house videogames, software programs, and movies, including ones now playing in theaters.

Not surprisingly, the big labels and the movie industry are trying to do to Kazaa, Grokster, and Morpheus what they did to Napster--litigate them out of existence. Only this time the outlaw networks may not be so easy to shut down. Kazaa, Grokster, and Morpheus work much the same way Napster did, but they're technologically smarter and, in a legal sense, a lot more amorphous. The Recording Industry Association of America (RIAA), representing eight record labels, and the Motion Picture Association, working on behalf of 19 movie studios, are suing the companies that own Kazaa, Grokster, and Morpheus--Sharman Networks, Grokster, and StreamCast Networks, respectively. (All three deny the charges.) But those entities don't run their networks the way, say, Sony does its record label; they have little control over what they created and can't tell who's downloading what file, whether it's an Eminem song or Grandma's recipe for blueberry pie. Thus the legal question becomes: If you can't control or see illegal activity, how can you be liable for it? In a memo leaked last December, the RIAA's legal team acknowledged that its claims against Kazaa, Grokster, and Morpheus "are not as strong as those against Napster."

What's more, even if there were a court order to shut down the networks, it may be impossible to do so. Napster operated with central servers that tracked and controlled the transfer of files between users, but Kazaa, Grokster, and Morpheus are completely decentralized. Niklas Zennstrom, one of the two creators of Kazaa, says that the only way the system can be shut down is if every user elected to disable his program. That, of course, isn't very likely to happen.

The beauty (or menace, depending on which side you're on) of the P2P networks is that they've taken on a life of their own. No one understands that better than Zennstrom, 36, and his 26-year-old partner, Janus Friis. Working out of a small office in Amsterdam, they put Kazaa on the Web in the fall of 2000 as an experiment, expecting maybe a few thousand people would download it. But after the ninth circuit appeals court dealt Napster its first crushing blow in February 2001, millions of Napster users flocked to the site.

The stampede scared even Zennstrom and Friis. They began frantically searching for someone to buy Kazaa, ultimately finding a British-born woman in Australia named Nikki Hemming, who quickly rounded up a couple of investors and formed Sharman. Zennstrom and Friis are still on the hook legally because they kept the underlying software, called FastTrack, that powers Kazaa and Grokster. The RIAA and MPA recently added both men to the lawsuit as individuals.

Like Kazaa, Grokster and Morpheus also grew by themselves. None of the networks has ever done a stitch of marketing to lure users. Digital-music fans go wherever there's software that lets them get their MP3 files. Short of suing 70 million-plus people or encrypting every CD and DVD sold (an unlikely scenario), it's hard to imagine how to stop it.

Still, the music industry has to try. Global sales of CDs have been falling; last year they were down 5%, and for the first time blank CD sales outnumbered sales for recorded CDs. "You really have no choice," says Cary Sherman, the RIAA's general counsel. "If you don't bring lawsuits, then thousands more of these networks will develop rather than the handful that pop up periodically."

Part of the RIAA's legal strategy is to show that Kazaa, Grokster, and Morpheus are guilty because they knowingly chose to design software that prevented them from having any control. "StreamCast was originally a centralized system, and after the Napster decision they became a licensee of FastTrack because they thought they could evade the court's judgment," argues Sherman. The RIAA also hopes to make an issue out of the fact that both Sharman and Grokster are incorporated offshore, the former in Vanuatu, a group of islands in the South Pacific, and the latter in Nevis, a 36-square-mile tourist paradise in the West Indies. (Morpheus is based in Franklin, Tenn.) "When Kazaa was about to get an injunction by a court in the Netherlands, it sold its assets to a company in Australia, and then they incorporated in Vanuatu, where there is no copyright law," steams Sherman. Hemming, speaking recently from her office in Sydney, says that the Vanuatu move was for tax purposes only, and that Sharman, whose headquarters are in Australia, intends to follow Australian law.

The RIAA is considering a far riskier strategy--suing individuals who share large numbers of files on Kazaa, Grokster, or Morpheus. It's a tactic guaranteed to infuriate and alienate music fans, and it underscores the awful bind record labels are in. "This is a time of crisis for the music industry, and the RIAA is trying to fight a battle on multiple fronts," says Susan Kevorkian, an analyst at IDC.

Unfortunately, the industry isn't putting up much of a fight on perhaps the most important front: creating Internet services that people actually like for legitimately licensed music. The RIAA can file lawsuits until it's blue in the face, but unless there are attractive legal alternatives, people will probably continue flocking to what record executives call the "pirates." P.J. McNealy, an analyst at GartnerG2, estimates that at least 15% of the people using P2P networks would be willing to at least consider paying for their music if it were packaged in an appealing way.

But it's not. Late last year several big record labels launched three online music subscription services, none of which is exactly the Amazon.com of online music. Pressplay and MusicNet have crippling restrictions on how much music you can download or burn onto a CD each month, and the songs that you do download basically self-destruct once you stop being a customer. EMusic, which is owned by Vivendi Universal, lets you own the music, but it uses the nonrestrictive MP3 format, and thus none of the major music labels want to deal with it, including, ironically, Vivendi's own Universal Music Group. The result is a narrow selection of obscure music from small, independent labels--more Nusrat Fateh Ali Khan than Moby.

Alan McGlade, CEO of MusicNet, which is owned jointly by Sony Music and Universal Music, says that improving MusicNet's offerings is a top priority. But he admits that it's a slow, painstaking ordeal. "This is an industry in formation, and there's no infrastructure," he says. "It's not necessarily clear within any label who's responsible for servicing content to us or how it's going to be licensed."

Meanwhile, hundreds of thousands of new users join the P2P party every week. Today it's Kazaa, Morpheus, and Grokster, plus four or five others. And if those networks somehow get shut down, others will pop up in their place. "These networks are just tools to get what I want," a Kazaa user named ErikZ said in an e-mail. "If the record industry breaks these tools, you go out and find another."

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