(FORTUNE Magazine) – According to legend, the gods bestowed on the Japanese people three sacred gifts: a mirror, a sword, and a jade jewel. The idea of the sacred trinity persists in Japan to this day, says Sony president Kunitake Ando. But the trinity now consists of a flat-panel digital TV, a DVD player, and a digital camera.

Given the current state of the consumer electronics business, one suspects that Ando would gladly trade, say, the DVD player for a good old-fashioned sword. That's because the industry's traditional leaders, most of whom are Japanese, are under attack as never before. The threat comes from scores of new competitors--ranging from faceless, low-cost Chinese manufacturers to powerful American PC companies.

A stroll through last month's Consumer Electronics Show (CES) in Las Vegas, where the industry's upcoming products were unveiled, tells the story. While the Japanese are still the undisputed leaders in high-end TVs, digital cameras, and most other major categories, more than half of the world's DVD players are now made in China. In mobile phones the leaders are Nokia of Finland, Motorola of the U.S., and Samsung of South Korea. Apple dominates the portable-music category with its iPod and iTunes Music Store; it must be galling for Sony, the inventor of the Walkman, to be more than two years behind Apple in the category. Gateway, a California PC maker, came out of nowhere to become one of the top sellers of plasma TVs in the U.S. In handheld computers Silicon Valley's palmOne is the PDA champ. Dell and Hewlett-Packard sit atop the global PC business, while in the fastest-growing segment, laptops, the Japanese leaders Sony and Toshiba are losing share.

Meanwhile, the PC titans, spearheaded by Intel and Microsoft, are loudly arguing that the PC is the hub of a new digital-entertainment lifestyle. And no wonder: The PC industry is basically mature, with flattened growth rates, while consumer electronics offers the steep sales growth and profits the PC giants crave. They say that their expertise in making intelligent, connected digital devices gives them a huge advantage over the traditional consumer electronics giants, which rose to power in the analog age. "The PC guys not only want a piece of the CE market, they want to own it," says Tim Bajarin, president of Creative Strategies, a Silicon Valley consultancy. "They want to take the PC model and deliver entertainment to the living room."

Or the hotel room. Wynn Las Vegas, a luxury hotel and casino scheduled to open in 2005, recently announced that it would put sexy, flat-panel plasma TVs in all its 2,700 guest rooms. Wynn chose not one of the Japanese market leaders but Gateway. This, too, is vexing to the Japanese companies, because in general they see the TV, not the PC, as the hub of the digital revolution.

Like most of the other PC companies, Gateway buys its TVs--along with DVD players and recorders, portable music devices, digital cameras, and other consumer electronics gizmos--from low-cost manufacturers primarily in Taiwan, mainland China, or Southeast Asia, where labor is cheap and engineering talent plentiful. By coupling the inexpensive, made-to-order products with their finely honed distribution and support systems, the PC companies can not only substantially undercut the Japanese leaders on prices for similar products but also sometimes beat them to market.

Those Asian manufacturers have learned a thing or two from their cut-out-the-middleman American PC customers. A visitor to the 2004 Consumer Electronics Show might conclude that dozens of new plasma-TV and DVD-player companies had sprung up overnight, and the observation is not far off the mark. These faceless upstarts with unfamiliar names--basically open-source hardware makers--eschew the proprietary technologies that the Japanese giants traditionally adopt as a way to add value and differentiate their products. These days proprietary hardware also means higher costs and slower time to market, a deadly combination.

Because of the cutthroat competition and commoditization of hardware, the best potential for profits in consumer electronics has shifted to value-adding software and services--not traditionally viewed as a Japanese strength. Until recently a company could prosper in the industry by inventing clever gadgets. The emphasis today is on digital media, including DVD movies, downloaded music, and digital photos, and by extension the smart, connected devices that manipulate and move those files around the house. Smart, connected devices are genetically closer to computers than to traditional consumer electronics products.

Shoppers are opening their wallets and purses to such relatively new offerings as online music services, satellite radio, video on demand, wireless networking, and online services like America Online or eBay, which, although increasingly common in Japan, are typically thought of as "made in America." "Software is the key," says Anthony Wood, who invented the digital video recorder and who now runs Roku, a Silicon Valley CE startup. "Because of software, we have great margins on our products, which should be scary to Asian companies because they're just plain bad at software. You go over there, and they're using techniques to write software that are 20 years old."

Not everyone agrees. Says Jen-Hsun Huang, president and CEO of nVidia, the world's largest maker of graphics-processing technology: "I'm surprised at how sophisticated the Japanese companies are." He notes that Panasonic and Sony, for example, have been fighting back by investing heavily in software R&D, forging alliances and partnerships with software companies, and merging their hardware expertise with the software skills of foreign partners. "In the end it will result in products that we've never seen before and that have never been built before," Huang says.

The Japanese companies heartily agree, of course. Jeff Cove, Panasonic's vice president for strategic alliances and business development, points out that his company is no stranger to competition; it has been battling other Japanese consumer electronics giants for years. Sony executives snipe at the "newcomers" to the field, saying they lack Sony's experience in delivering exciting new products to consumers. And an executive at another Japanese electronics giant dismisses the PC rivals as "dilettantes" and "distributors rather than innovators."

Even the Japanese acknowledge, however, that a good mirror is as necessary as the sword. They'll need it to examine their role in the coming digital world.

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