(FORTUNE Magazine) –

It was the first crime of its kind in China: Last year a 40-year-old man used a real knife to stab to death a younger man who had borrowed his virtual sword from an online videogame and sold it for $870. There are no laws in China protecting virtual property, so Qiu Chengwei, the man whose sword had been stolen, got no help from the police. Instead he tracked Zhu Caoyuan to his one-room apartment in Shanghai and, in the presence of Zhu's girlfriend, plunged a knife into his heart.

The crime earned Qiu a death sentence. It also sent shivers through China's fast-growing and increasingly controversial gaming industry, which has been accused of causing obsessive and sometimes violent behavior. Nowhere has that backlash against videogames been more keenly watched than at the Shanghai headquarters of Shanda Interactive Entertainment, China's biggest gaming company. Shanda specializes in online role-playing games that draw thousands of players together in their virtual worlds. Although it doesn't operate the game that Qiu and Zhu were playing--Legend of Mir III--it does operate the even more popular version, Legend of Mir II, featuring Asian warriors. And for Chen Tianqiao, Shanda's founder and CEO, the backlash is one more reason that he's racing to transform his successful videogame company into a more broadly based entertainment conglomerate--one he hopes will become China's Disney.

This isn't the first time Chen, a quiet, unassuming 32-year-old, has made a counterintuitive bet. Four years ago, with the dot-com bubble bursting and the $3 million in venture capital he had raised for an online cartoon website running out, Chen forked over his last $300,000 to a South Korean company for the Chinese rights to Legend of Mir II. His friends thought he was crazy. No sooner had other companies launched videogames in China than pirated copies flooded the streets. But Chen, who graduated in economics from Shanghai's prestigious Fudan University, had a deceptively simple yet ingenious plan: He would give the software away free and get players to buy time on the company's servers. For as little as 3 cents an hour, they could interact and compete. "They cracked the piracy problem," says Duncan Clark, chairman and co-managing director of BDA China, a Beijing technology consulting firm. "In China shrink-wrapped products don't sell."

Chen's gamble paid off: Within two months the company was profitable. Last year it went public, and it now has one of the largest market capitalizations ($1.8 billion) of any Internet company in China. Online role-playing games, like Legend of Mir II and others the company has developed on its own, offered China's young people an escape from the barren entertainment landscape of state-run television and poor-quality knockoffs of Western movies. For many it was an escape from reality itself. Teenage boys and young men streamed into Internet cafés to log on to Shanda's games and assume the identities of warriors, monks, and magicians in order to kill monsters and one another. Online gaming became a national obsession, with as many as 2.5 million players logging on to Shanda's games at once. Revenues doubled every year, on average, reaching $61.7 million in the third quarter of 2005, up 41% from the previous year. Net income grew too, jumping 58%, to $32.3 million, in the same period. And Shanda's stock--listed on Nasdaq--nearly tripled after the IPO before cooling off in recent months.

Now Chen is betting against conventional wisdom again. Although industry analysts expect China's online gaming industry will continue to expand by 35% a year for the next five years, Shanda is looking to diversify into other forms of interactive online entertainment. For a company used to doubling in size every year, 35% growth isn't good enough. "If we want to keep Shanda growing very quickly," Chen says, "we have to expand, to broaden our demographics."

Over the past year Shanda has taken the $150 million it raised in its public offering and another $275 million from the sale of convertible bonds and bought several companies, many beyond the realm of online gaming. After buying Digital-Red, a provider of games for cellphones, and Qidian, a literature website, Chen made waves by spending $230 million to acquire 19.5% of Sina.com, China's premier Internet portal and news site. It was the closest thing the country has seen to a hostile takeover. Shanda has also teamed up with Baidu, one of China's top search engines, and it is partnering with Universal Music to offer digital downloads.

The company has been expanding its reach in the gaming world too, with a move into so-called casual games--online arcade offerings, often in the style of Super Mario Bros. but with hundreds playing at once. The games are free, but users pay for upgrades to provide their characters with clothing or hats, say, or to change the background. "It's just like you'd buy something at the shopping mall," says Frank Liang, Shanda's associate director of investor relations. "Everyone wants to look different from the others."

But Chen's biggest bet is on a new set-top box called EZ Station, designed to bring the Internet to the country's 370 million televisions. To Chen, a marriage of broadband with television could bring Shanda to those who might not frequent a cybercafé or use a home computer. The box, which began selling in late October for $849 in one test market, features a jack for ADSL, a cable for television, and the tantalizing promise of piping the Internet--and Shanda products--directly into the living room.

Shanda is still trying to grow its online role-playing games. It currently offers six titles, including four developed in-house, and it's planning a fantasy cartoon game and a new 3-D role-playing game that would compete with World of Warcraft, a popular new game operated by rival The9. But role-playing games now account for only two-thirds of Shanda's revenue, and the company's managers expect that figure to keep dropping. "The natural growth of the gaming industry is higher than that for just role-playing games," says Li Shujun, Shanda's chief financial officer.

The epicenter of China's gaming revolution is a four-story office park in the distant reaches of Shanghai's Pudong district. In the reception area, above an aquarium, a flat-screen TV loops a trailer for Magical Land, a cartoon-style online role-playing game targeting young girls. Most visitors head through a side entrance to Shanda's customer-service center, where clerks behind glass handle cases of lost passwords and theft of virtual equipment by hackers. Some customers have traveled more than 800 miles. (The company requires people who forget their password to show up in person with ID.) "If you were cheated by your friend, I can't solve that problem for you," says Li Li, a 24-year-old clerk.

In another wing sit 300 telephone operators, who field questions from callers 24 hours a day. They are testimony to Chen's view of the industry. "Online gaming is not a product, it's a service," he says. "The first month we got profitable, we invested in the call center." In another room, technicians monitor real-time digital graphs that track how many users are logged on to Shanda's games. (The company has a network of 14,000 servers that can accommodate as many as 5.9 million users at once.) "A lot of people think of games as whoever has the hottest product will be the winner," says Zhou Donglei, head of investor relations. "But it's really not. It's who has the most stable platform." Or, as Chen puts it, "If you want to live in a house, first it should be strong enough. Then we can add the decorations."

Most of Shanda's headquarters is devoted to game development. The company employs 2,000 workers (average age: 25), who are expected to know what their game-playing peers want. In cubicle after cubicle, designers draw new monsters, map new lands, dream up new gear, mastermind challenges for players, and test their co-workers' products. The company has recently invested in motion-capture equipment to speed animation, and it has brought in actors, professional dancers, and martial artists to lend their moves to the characters. The motions range from a simple wave of the hand to flying kung fu kicks. "We even have expressions," says Cai Ying, a 23-year-old motion-capture engineer. "The actor does some motion showing that he's hungry or happy."

Shanda employees sometimes enter their own online worlds. On a recent day Hu Zhenkai, 24, was leading several dozen online Legend of Mir II players into a virtual cave. Logged on as a game master, a special character that can't be harmed, he waited in a clearing near some trees. An armored knight with white, feathery wings arrived and slashed at him with a sword (a standard greeting). Other characters appeared, one followed by a pig, another escorted by a skeletal henchman. Hu led them through twisting corridors, around gray stalagmites, and past the corpses of bat-winged beasts. Every so often a blue bolt would blast him: a new arrival, saying hello. When the last beast, a giant dragon, succumbed to the barrage, the players were rewarded with snowmen that exploded into piles of gold.

The very features of the games that pull players in--their violence, their ability to shunt the real world aside--make them unpopular with parents and the government. The Chinese press delights in linking videogames with obsessive or violent acts. A 13-year-old boy jumps from a 24th floor with his arms stretched forward in a flying posture, leaving a note that says he is joining three virtual friends. Another teenager, accustomed to dodging bullets in a popular videogame, can walk only in zigzags. A man protests a game by setting himself on fire.

Each report turns up the heat. "The values and rules in these online games are completely different from real, physical society," says Shang Jiangang, a lawyer with the Shanghai Industry Association of Online Professionals, a group of gaming companies tasked by Shanghai's municipal government with considering industry regulations. It wouldn't be the first time the government intervened to protect the young. When PlayStation arcades elicited similar complaints in the 1990s, officials forced them to close. Last year many telecom companies took a hit when a crackdown on short-messaging systems cut off an important revenue stream. After a fire in an Internet café killed 25 people in 2002, the government began restricting their use. Players must prove they are 18 or older, and the cafés, where nearly half the online gamers play, must close at midnight. Universities have blocked access to game servers, and schools have banned cafés in their neighborhoods. The obsessive nature of online role-playing games--their "stickiness," in Shanda's parlance--helped build the industry. Now that stickiness threatens to undermine it.

So far the government's focus has been on limiting playing time, mainly by introducing the concept of fatigue--points earned by players are automatically reduced after the first few hours of play. In August officials issued regulations requiring that players have their online characters' powers diminished after three hours of play and severely restricted after five hours. Seven of China's largest gaming companies, including Shanda, pledged to implement the system. Other proposals include speeding up character advancement, banning those under 18 from playing games that involve killing other players, restricting the trade in virtual weapons, and introducing a rating system like the one for movies in the U.S. Though Shanda seems to be currying favor with the regulators--in September it announced it would team up with the government to develop patriotic games featuring historical characters approved by the Communist Party--the restrictions could squeeze gaming revenues. Against this backdrop, Shanda's diversification strategy looks less like a gamble.

When Chen moved into online role-playing games, he had the China market to himself, and for four years his games were the most popular in the country. Now, Legend of Mir II is showing its age: Revenue dropped 34% in the third quarter. For for the first time, another game--Netease's Fantasy Westward Journey--holds the No. 1 spot. And World of Warcraft has become a runaway success since its launch in June.

Whether these rivals are luring customers from Shanda or expanding the market is a subject of debate, but they're one more reason that life in the gaming business is becoming a little more uncomfortable for Chen. James Rhee, who handles investor relations for The9, reckons there's room for several corporate players in a growing market. "New players are being drawn in who have never played in the past," he says. But Chen isn't so sanguine. "The competition to acquire the games is increasing," he says, "but the demographics are remaining fixed."

That's why the EZ Station is so important to Shanda's future. Like a character in one of his games, Chen wants to stay ahead of hungry competitors nipping at his heels, perhaps even slay one or two. So he has lined up 48 content partners to offer a variety of entertainment products appealing to many segments of the population. Chen imagines teenagers playing fantasy games, parents playing educational games with their children, grandparents playing mahjong online, and whole families singing karaoke in front of their TV sets. "Maybe you can't overcome the piracy problem on the content side," Chen says, "but you can control the channel side and charge for it."

In October he unveiled two additional weapons: the EZ Mini, a handheld wireless gaming device that will be rolled out later this year, and the EZ Center/EZ Pod, software developed in partnership with Intel (which also provides the chip set for the EZ Station) that enables a normal PC to be operated by remote control, like a television set. Failure to get a return on those investments could damage the company. "It's a high-stakes game," says Clark of BDA China. "The market is not mature yet."

But Chen likes his odds. "If we can double in the next five years, every year, then maybe we can have the same valuation as Disney," he says, without a hint of humor in his voice, adding that he expects to push out to Asia and then the U.S. in the next few years. "Now we are at nearly $2 billion, and Disney is at about $40 billion to $50 billion. If we double five times ..." His voice trails off. "It's not a target," he says. "It's a dream. It's my dream."