NEW YORK (CNN/Money) - One of the most acrimonious rivalries in the world of business appears to be drawing to a close.

Microsoft and Sun Microsystems announced Friday that the two companies had agreed to end all litigation against one another and collaborate on server software technology. In addition, the companies agreed to pay each other royalties for the use of each other's technology.

Sun Microsystems chairman and CEO Scott McNealy has been one of Microsoft's biggest critics.

As part of this agreement, Microsoft will be paying Sun $700 million to settle antitrust issues, $900 million to settle patent litigation and $350 million in royalties. Sun said it would pay Microsoft royalties once it begins incorporating Microsoft technology into its products.

The settlement came as a huge shock to many since Sun Microsystems chairman and CEO Scott McNealy has been an outspoken critic of Microsoft for the past decade. One analyst joked that if the announcement came a day earlier, on April Fool's Day, he would have thought it was a joke.

"I had to check my calendar," said Michael Cohen, director of research for Pacific American Securities. "And I also had to check to make sure that hell didn't freeze over."

During a press conference Friday, McNealy acknowledged how strange this turn of events was. "I know a lot of you think this is kind of weird," he said, referring to the sight of him sitting next to Microsoft CEO Steve Ballmer at the press conference in San Francisco. Microsoft chairman Bill Gates was not at the conference.

Adding to the surreal atmosphere, McNealy and Ballmer, who both grew up in Michigan, gave each other Detroit Red Wings hockey jerseys and talked about being friends. The two said that they began to hash out terms of the settlement at a golf outing last year.

The settlement comes a week after the European Union fined Microsoft more than $600 million for antitrust violations and proposed tough sanctions that could make it tougher for the company to continue bundling key features into its popular Windows operating system. Microsoft has said it would appeal the decision.

But in another interesting development, Sun, which had pressured the EU to take a look at Microsoft back in 2000, said that the terms of its settlement with Microsoft satisfied " the objectives it was pursuing in the EU actions pending against Microsoft." That could help Microsoft negotiate a better deal with the EU, said David Hilal, an analyst with Friedman Billings Ramsey.

Wall Street appeared to think that the new spirit of détente was great news for both companies.

Shares of Microsoft (MSFT: Research, Estimates) gained more than 2.5 percent Friday afternoon. Sun (SUNW: Research, Estimates) surged nearly 20 percent...despite the fact that the company also announced Friday that fiscal third quarter sales would be lower than expected and that its quarterly loss would be bigger than anticipated. Sun also said it would lay off 3,300 workers, or about 9 percent of its workforce.

In the case of Microsoft, the settlement gives more hope to investors that the company will soon be able to put some of its cash to better use, i.e. increasing its dividend, buying back more stock, or making an acquisition, said Matthew Kelmon, president of Kelmoore Investment Co, which owns both Sun and Microsoft.

"Now Microsoft has no excuses. The cash is going to be put to work," said Kelmon, adding that the company might finally begin to participate in the rally that has lifted most other tech stocks over the past year.

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Even though Microsoft will be paying nearly $2 billion to Sun and more than $600 million to the EU, depending on what happens with Microsoft's appeal, that's just a small dent in the $52.8 billion in cash on Microsoft's balance sheet. Investors appear to be just relieved that Sun has settled.

"This is the one legal issue that was a big thorn in Microsoft's side and most people were led to believe is that this would drag on and on and on," said Hilal.

Hilal added that Microsoft was wise to agree to cooperate with Sun on Web software standards. Sun's Java software is widely popular in the tech community but Microsoft has made a push into this area with its .Net initiative. "Web services are only going to work if Java and .Net are going to be interoperable," Hilal said.

Still, Ballmer was quick to point out that Microsoft and Sun will continue to compete against each other as well.

As for Sun, the fact that McNealy will no longer be waging his crusade against all things Microsoft is a huge plus for the company. McNealy admitted that customers had been telling him for the past year to cut the rhetoric and work on making its products interoperable with Microsoft's.

Of course, Sun still obviously faces some major short-term problems. Rivals such as IBM, Hewlett-Packard and Dell continue to gain market share in the server market, once Sun's bread and butter domain. And in large part, their success can be attributed to the fact that they sell servers running on Microsoft's Windows Server system.

But the addition of nearly $2 billion in cash will further strengthen Sun's balance sheet. The company currently has $5.2 billion in cash and investments. What's more, Sun also announced Friday that it had finally decided to name a new chief operating officer.

Jonathan Schwartz, formerly the head of Sun's software division, was promoted to president and COO. McNealy had held the role of president since Ed Zander, now the chairman and CEO of Motorola, left Sun in 2002. That led to some concerns on Wall Street about Sun being too much of a one-man show.

Tapping Schwartz, who is just 38, to this role seems to put him in line to eventually succeed McNealy. Cohen said this is significant when you look at all of Friday's news.

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He said the promotion of Schwartz and the decision to cooperate with Microsoft could show that Sun is moving more toward becoming a software company that can piggy-back off Microsoft's success as opposed to a proprietary hardware firm that is continually losing ground to Microsoft.

"Software really now has to be at the head of the company's strategy so it makes sense to have Jonathan at the role he's in," said Cohen.

All in all, Friday marked the beginning of a new era for both Microsoft and Sun, and it's one that has pleasantly surprised tech followers.

"I never thought I'd see this day," Kelmon said.

Analysts quoted in this story do not own shares of Microsoft or Sun and their firms do not have investment banking relationships with the companies.