(FORTUNE Magazine) – In the heart of downtown Taipei, a bronze statue of the Generalissimo seems to brood over his legacy. Chiang Kai-shek, visitors to his memorial are told, was "the first statesman of world stature to see the inherent dangers of world communism." Perhaps it's the smog that makes the Generalissimo's features seem a little tarnished these days. But perhaps it's that, 22 years after his death, Taiwan is no longer his kind of place. Across this last bastion of "Free China," people are doing business with the enemy. Big business.

Taiwan investors, like those elsewhere, are attracted by China's cheap labor and status as the world's largest emerging market. For the Taiwanese, China also offers special tax breaks and incentives. So far, according to Chinese figures, Taiwanese companies have invested $15 billion on the mainland and have promised some $20.6 billion more, making the island the No. 2 investor in China, after Hong Kong.

All this leaves the government in Taipei feeling a bit queasy--particularly since China is determined to reunify with Taiwan. If necessary it would use force. Last year China lobbed live missiles close to the island during democratic elections to warn the breakaway republic against any thoughts of independence. President Lee Teng-hui has been trying to limit the amount of investment in the mainland, most recently with a May 28 ruling that bans investment in infrastructure projects such as railways and power plants and puts a $50 million cap on any China venture.

But such curbs could backfire, Taiwanese business executives argue. They say that if they don't invest in China, their rivals in Korea, Japan, or the U.S. will, weakening Taiwan's competitive position. And China could retaliate by cutting Taiwan's channels through Hong Kong, which on July 1 becomes a special administrative region of China. The bulk of Taiwan's exports to the mainland--at least $19 billion last year--pass through Hong Kong. And China absorbs 16% of Taiwan's exports, according to official statistics; once re-exports from Hong Kong are counted, the figure is even higher.

Taiwan's problem is that both business and the government may be right. Either investment strategy--keeping the mainland at bay or accepting China's embrace--could undermine Taiwan's economic clout. And there's no obvious middle course. Either Lee Teng-hui or Taiwan's corporate big league will have to back down, and in Taipei, no one is putting money on the President. So far the government's record in restraining the island's China-obsessed businessmen has been poor. And with the July 1 handover, it's getting harder to hide the growing cross-strait trade and investment behind the Hong Kong fig leaf.

Commercial relations were so much simpler back in the days of the Generalissimo: There were none. After Chiang's defeated armies fled China in 1949, he swore "no contact, no compromise, and no negotiation" with the enemy. Then in the 1980s, under Chiang's son and successor, Chiang Ching-kuo, a low level of indirect trade between Taiwan and China was tolerated by the government. But it was not until 1988, after the younger Chiang (who died the same year) had lifted the ban on travel to the mainland, that Taiwanese investors started moving to China in force. Later that year Lee's government eased the ban on investments, tolerating ventures that were officially approved and were routed through a third country, usually Hong Kong, provided they didn't jeopardize Taiwan's economic interests. By March 1990, China claimed that it had received more than $1 billion in Taiwanese investment.

Taiwan disputes the statistics but not the trend. In July 1992, concerned that so many companies were ignoring its decrees, it declared an amnesty and gave businesses three months to register their PRC ventures or risk further penalties. What happened? Even more companies flocked to China, often sidestepping the regulations.

To understand the peculiar difficulties that the Taipei government faces in trying to rein in its companies, one need go no further than Jack T. Sun, one of the island's corporate heavyweights. Executive director of the quasi-official Chinese National Federation of Industries, Sun is also chairman of Taiwan Aerospace Corp. As the head of a company that is 35% state owned, he's also a loyalist in the debate over cross-strait capital flows. "Our government policy to restrict investment in mainland China is correct for the time being," says Sun. His words carry less weight when recent activity at Taiwan Aerospace is taken into account. In April, Sun's company sought government approval for a joint bid to buy a 5% stake in a $2.5 billion consortium developing a new generation of jet aircraft in the People's Republic. Approval was denied by the Economics Ministry, which happens to own Sun's partner in the bid, Aerospace Industry Development Corp.

If the government can't even keep its own companies from contracting China fever, how can it then limit the actions of private-sector firms? With ever-increasing difficulty. Consider the case of Y.C. Wang, chairman of Formosa Plastics Group, Taiwan's largest private conglomerate. Wang would like to take a majority holding in a $3 billion mainland power-plant project--a venture that would dwarf any previous PRC stake by a Taiwanese company. Under the latest investment rules issued in May with Wang very much in mind, such a deal would clearly be off-limits. Indeed a spokesman for Wang's company said that the venture now looks "improbable." However, in March Wang said he had already broken ground for the plant using capital from a Formosa Plastics subsidiary in the U.S. Wang could probably continue that project via the U.S. subsidiary, and Taipei could do little to stop him.

Smaller, lower-profile companies can funnel their investments through holding companies in Hong Kong to avoid Taipei's scrutiny. Huang Chintan, a senior regulator at Taiwan's Economics Ministry, admits that numerous small companies will continue to slip through the net. "It's true," he says, with a resigned shrug, "many companies violate the rules, and we cannot find them."

It's the medium-sized companies, which rely on Taiwan's government-controlled banks for financing their China ventures, that have to toe the line. William Shang is ruefully aware of that. "We have to be good babies," says Shang, president of Chung Shing Textile Co., one of the world's biggest makers of underwear, which operates 13 factories on the mainland. Shang, attracted by wages that are about one-sixth those in Taiwan and by the growing market in China for his Three Guns brand of garments, would like to expand his Chinese manufacturing base. But he can't because of Taiwan's increasingly strict rules on cross-strait investment. "It's very inconvenient," protests Shang. "First the government encourages us to go to the mainland; then all of a sudden they say you should think again."

Just how complicated a minuet Taiwan is dancing with China is shown by the negotiations over direct shipping links across the Taiwan strait. Taiwan forbids direct links, sending its goods via Hong Kong; China wants to start them, and so do many Taiwanese business people. A compromise sealed in April after two years of painstaking negotiations allows direct shipping only between China's second-string ports of Fuzhou and Xiamen, and Kaohsiung on the Taiwan side--provided the goods are destined for onward transit to a third country.

Similarly circuitous is the compromise signed in May over the flagging of Hong Kong-bound ships now that the territory is part of China. Taiwanese ships in Hong Kong waters will fly no flag--rather than the one of a breakaway republic--while Hong Kong ships in Taiwanese waters will hoist the colors of the new special administrative region.

It was pressure from Taiwan's own shippers, as well as Beijing's intransigence, that forced Taiwan to swallow its national pride on the flagging deal. But the shippers--and China--still aren't satisfied; they want full, unrestricted cross-strait shipping. Johnny Kuo, president of Taiwan-based Uniglory Marine, wants his container lines to have access to major Chinese ports like Shanghai. China has so far denied them this prize, hoping to force Taipei to relax its maritime restrictions first. "All the Taiwan shipping companies see this as just a steppingstone," says Kuo. "First, knock at the door, and the next step is to come in."

Bargaining over access to its ports is just one of the ways in which China is trying to maximize its economic leverage over Taiwan. Another is ensuring that all those mainland-based Taiwanese ventures (up to 30,000, according to Beijing) feel right at home. So China has set up dozens of Taiwanese investment zones that offer tax breaks. A handy "home return permit" is all Taiwanese business people need to reside in China. In the southern city of Xiamen, just across the water from Taiwan, the municipal government has passed a law for the protection of Taiwanese investors and established a department to deal with their complaints. Among the grievances covered by the city ordinance: "bullying" by Xiamen business partners and clients.

In fact Xiamen is a good vantage point to observe the new, friendly face of China toward Taiwan. Taiwan still holds a group of small islands just a few miles from Xiamen, and on a clear day mainland tourists rent telescopes and peer out to sea at enemy territory. There was a time, in the 1950s and 1960s, when the opposing sides rained shells on each other; then they fired propaganda barrages, until finally they resorted to megaphone diplomacy, using loud hailers to exchange insults.

As hostilities subsided in recent years, Xiamen became the scene for a peaceful Taiwanese invasion. At its airport groups of Taiwanese tourists deplane bearing spirit houses to place by the graves of their mainland ancestors. Tourism led to investment; today there are about 5,000 Taiwanese executives living in Xiamen, whose companies have pumped more than $2 billion into the city. Xiamen's deputy mayor, Su Shuili, insists that last year's missile tests were barely noticed by Xiamen's Taiwanese community.

That's hard to believe--until you put the same question (admittedly under the watchful eye of a municipal official) to Taiwanese managers in Xiamen. "I would say that most Taiwan business people in mainland China knew the missile tests were just for show," says Tien Chu-ying, the 35-year-old executive vice president at Tsann Kuen, a Taiwanese firm producing domestic electrical goods.

Tsann Kuen is the kind of company that gives President Lee cause for worry. The company moved into Xiamen eight years ago and now generates over $100 million annually from its China operations. Last year, for example, the company sold over four million irons worldwide under its Eupa brand; this year the production target is 5.3 million. Meanwhile Tsann Kuen has ceased all manufacturing in Taiwan. And China's campaign to win hearts and minds is clearly succeeding with Tien. "People of my generation in Taiwan reckon that if you want to upgrade your prospects, you've got to come to the mainland sooner or later," she explains.

Don't be fooled: China is still China. When the Sheng Da sailed from Xiamen port for Taiwan on April 19--the first authorized direct voyage since Chiang Kai-shek's day--it wasn't mentioned in the local press. Ask Xiamen's deputy mayor to explain the omission, and he reverts to cadrespeak: "Because I am not in charge of propaganda, I'm not so clear about this."

That kind of mindset highlights the essence of Taiwan's China problem. It's possible to disagree about the economic risks of investing on the mainland. It's possible to debate the scale of the cross-strait military menace. But it's impossible to deny the huge political gulf between Taiwan and China--one that makes Beijing's reunification formula of "one country, two systems" out of the question for virtually all Taiwanese.

All of which leads to the question: Why do business with people you don't trust? The wishful theory, aired by some Taiwanese executives, is that constructive economic engagement will help narrow the political gulf. "I feel their way of thinking improves," says Uniglory's Kuo. "They're becoming more Westernized, more alive, especially in the coastal areas." Yet when he and other corporate leaders are pressed for their own reunification timetable, they talk about decades, not years.

Meanwhile it doesn't appear that Taipei can stem the tide of companies flowing across the strait. A key test will be the actions of Formosa Plastics. In 1992 the group abandoned plans to build a $6 billion petrochemical complex on the mainland following intense government pressure. Wang's reward, industry analysts believe, was permission to develop an even bigger petrochemical plant on Taiwan. But for the current project, Taipei has no comparable bounty to dispense. That's bad news for Wang. But it could end up being even worse news for Lee's government. Wang may soon be sizing up his next China venture. If he moves, the tide of investors across the strait could turn into a flood.