(FORTUNE Magazine) – In late February 2002, the users of an online file-sharing service called Morpheus found themselves suddenly cut off from their network. Their mass freezeout, it developed, had been engineered by a rival file-sharing service called Kazaa, from which Morpheus licensed key software. Kazaa claimed that Morpheus had fallen $30,000 behind in its licensing payments, so it pulled Morpheus's plug.

What made this otherwise mundane business spat so startling was that the network Kazaa and Morpheus were using wasn't supposed to be capable of being switched off--by anyone. On the contrary, it was thought to be decentralized and "self-organizing"--a network that would continue to exist even if Kazaa and Morpheus were to vanish.

If you happened to read about this incident at the time, you probably dismissed it as a matter of interest only to techies or teenagers. Yet it has become a matter of transcendent interest to lawyers for every major record label, motion picture studio, consumer-electronics manufacturer, telecommunications carrier, and information technology player in the world. The puzzling shutdown has triggered an international wild-goose chase that has sent entertainment industry lawyers bouncing from Los Angeles to Amsterdam to Sydney to Estonia to Guernsey, to chase down arcane but legally crucial details of the network's inner workings. That chase, futile so far, demonstrates why the U.S. Supreme Court or Congress may soon have to revisit a landmark 1984 court ruling that has been hailed as the "Magna Carta of the technology age."

Entertainment companies say that the time has come to modify that court decision--popularly known as the Sony Betamax ruling. Equipment manufacturers insist that it remain inviolate. As judges try to force perplexing new technologies into the outdated conceptual pigeonholes bequeathed by the Betamax ruling, they are reaching conflicting results. While attention has focused on the record industry's suits against individual file sharers, this battle, a far more important one for the future of entertainment and technology, has been rolling implacably toward the highest court in the land.

For two technologically eventful decades, the Betamax case--formally, Sony Corp. of America v. Universal City Studios--has defined the tense frontier that divides the rights of entertainment companies from those of technology providers. The conflict arises from a fundamental tension. Copyright laws grant creators a monopoly over the right to reproduce and distribute their works during the term of a copyright. Technology providers make devices that enable consumers to reproduce and distribute copyrighted works--photocopying machines, VCRs, TiVo, "ripping" software, CD burners, and high-bandwidth cable and DSL lines, to name just a few. Does that mean those technology providers are facilitating copyright infringement by their customers? Must technology providers be perpetually seeking permission from entertainment companies every time they want to develop a new invention capable of reproducing a copyrighted work?

Since 1984, the answer in the U.S. has been a resounding no. In the Betamax case the court decided that Sony, by marketing VCRs, could not be held liable for facilitating copyright infringement, even though it knew that some consumers would use its VCRs illegally. The VCR's "primary" uses, Justice John Paul Stevens noted, were noninfringing. But his ruling then went a step further. He suggested that any technology provider should be protected as long as the device it marketed was "capable of substantial noninfringing uses"--even if the device was not currently being used that way. The idea was that courts should not stifle potentially beneficial technologies in their infancy, before their usefulness might be fully understood.

In the intervening 19 years digital technologies have supplanted analog, and technology providers have devised ever faster and cheaper ways for their customers to copy and distribute content. As a result, the perils those technologies pose to copyright holders have increased. At the time of the Betamax ruling the studios had not yet been able to show any actual revenue loss attributable to VCRs, even though VCRs had already been in circulation for almost a decade. In contrast, since 1999, when a 19-year-old college kid launched the first music file-sharing service, Napster, unit sales of recorded music have dropped 26% and record industry revenues have fallen 14%--a $2 billion decline. It was a measure of the industry's desperation that last month the Recording Industry Association of America sued 261 file-sharing music fans, knowing full well that it was asking for a public-relations shellacking. Predictably, a 12-year-old girl was among those swept up.

Record industry executives have proved an unsympathetic lot, easily caricatured as overpaid middlemen with ponytails and Malibu beach houses. But the potshots are a diversion. Yes, most recording artists never see any back-end royalties. That's because most recordings never make back the artist's front-end advances and other investments that companies charge to their artists' accounts. But regardless of whether you think these contracts are fair, it should go without saying that when the back-end royalties dry up, so do the front-end advances and investments. The artists--particularly unestablished ones--do pay.

As a practical matter the incomes of songwriters are even more directly tied to CD sales than those of recording artists. "At first I didn't know what was happening," says Barbara Dozier, the wife of Motown songwriter Lamont Dozier. For more than 20 years she has handled her husband's business affairs, monitoring his royalties from more than 600 songs, including 76 top-ten hits. ("Stop! In the Name of Love," "How Sweet It Is," and "Bernadette" are among them.) A few years ago she began to notice that while Dozier's radio royalties were holding up, his royalties from CD sales were plummeting. "Finally I realized it was the file sharing," she says. An income stream that Dozier had counted on to serve as an annuity has been cut in half, she says.

While Dozier's personal predicament is troubling, it is the public interest that the copyright laws are supposed to protect. On the one hand, a large part of the public loves having access to all of Dozier's work free. But copyright laws also seek to set up financial incentives so that creators choose to use their gifts--which also benefits the public. We don't want the next Lamont Dozier to see what happened to the last one, chuck his artistic aspirations, and become a software developer.

"Contemporary technologies--and not just the file-sharing services--are putting a lot of pressure on the Sony formula," says Stanford Law School professor Paul Goldstein, a copyright specialist. "We're talking about technologies with effects that are different from those of a VCR. Whether it's going to be the U.S. Supreme Court or Congress, I think at some point it's going to get reexamined."

Kazaa, Morpheus, and Grokster are all descendants of Napster. They quickly sopped up Napster's audience after the recording industry chased Napster through the courts and into oblivion in July 2001. (The unrelated Napster 2.0, which launched this month, is fully licensed and not peer-to-peer.) Like Napster, the second-generation file-sharing services enable their users to search one another's PC hard drives and copy digital files. Unlike Napster, however, which was limited to music, these services also offer access to movies, videogames, software, images, and text. At peak volume last month, the Kazaa system attracted almost 4.5 million simultaneous users, according to the online media measurement group BigChampagne. About 90% of the files available there are copyrighted music and movies, according to an entertainment industry analysis.

Because of all the people who are drawn to file-sharing networks--attracted in large part by the opportunity to get copyrighted works free--the services are able to make millions of dollars by selling advertising. They bundle adware with their desktop file-sharing software. The adware automatically launches whenever the file-sharing software is launched. The services currently share none of their ad revenues with the copyright holders.

To be sure, the services do offer some files that are authorized for distribution. I found a PDF file of Shakespeare's sonnets on Kazaa, for instance, and Shakespeare's works are in the public domain. Some bands make their concert recordings available to these services, as do some lesser-known artists hoping to be discovered.

But authorized files aren't what give these businesses their commercial punch. We have some empirical evidence on that question. Starting in mid-March 2001, the courts ordered Napster to begin filtering copyrighted files out of its system. Napster's volume of simultaneous users fell from more than two million before the filtering began to 400,000 shortly before Napster euthanized itself. The number of files available fell 95% during that stretch, according to documents that surfaced during Napster's bankruptcy.

Though some file-sharing companies have offered to pay copyright holders a slice of their revenues in exchange for peace, such proposals are laughable from the entertainment industry's perspective. The services' earnings are trivially low compared with what the industries stand to lose in sales. Since the services have paid nothing for the content that sustains their businesses, they have no incentive to price it at anything resembling what its creators think it's worth. If I steal a $50,000 Mercedes, I'm happy to fence it for $100, because the $100 is pure profit to me. (Not to sound judgmental.)

Faced with this predicament, the movie and music industries sued Kazaa, Morpheus, and Grokster in Los Angeles federal court in October 2001, alleging facilitation of copyright infringement.

But litigation is futile!, many readers will protest. If you shut one service down, others will spring up! They'll just set up offshore in countries that don't honor our copyright laws!

"We have no illusion of ever getting rid of piracy entirely," responds David Kendall, the studios' lead counsel in the litigation, which is known as MGM v. Grokster. (You may remember him as President Clinton's lawyer during the impeachment proceedings.) The goal, Kendall explains, is to shut down the commercial services, which are more user-friendly than the complicated noncommercial methods employed by techies. Even if the for-profits move offshore, Kendall notes, their advertisers are mainly U.S. companies, and the studios can attach the services' advertising revenue. "We're just trying to make file sharing harder for users than legitimate alternatives," he says, referring to the licensed online music services that are now proliferating and improving.

But the Grokster litigation has been a fiasco so far. The problem stems from the Napster precedent. Though the music industry won, the appeals court's reasoning was narrow, leaving the industry little legal ammo with which to wage follow-up battles.

Napster had asserted the Betamax case as its shield. Since Napster was capable of noninfringing uses, it was protected under Betamax even if its actual use was overwhelmingly for infringement, its lawyers argued. The appeals court agreed that was a correct reading of Betamax, but found that Betamax simply didn't apply. The reason: Napster was a service, with an ongoing relationship with its users, whereas the VCR was a product that Sony put into the stream of commerce and then had nothing more to do with. While Sony could not patrol what its end users did, Napster could. Napster kept indexes of all the file names its users were trading on centralized servers on its premises. It could see what users were trading. For that reason, the court decided, Napster could be ordered to filter out copyrighted files.

For software developers, however, the Napster ruling was a speed bump. Fred von Lohmann, an attorney with the Electronic Frontier Foundation in San Francisco, posted advice to developers on the EFF site suggesting ways to engineer around the Napster ruling. "Better to sell stand-alone software products than ongoing services," he recommended. "Can you plausibly deny knowing what your end users are up to?" he urged them to ask themselves. "Disaggregate functions," he exhorted. "If each activity is handled by a different product and vendor ... each entity may have a better legal defense to a charge of infringement. A disaggregated model ... may limit what a court can order you to do to stop infringing activity by your users."

Even before the EFF issued these "lessons and guidelines," at least one service already fit the bill. By late 2000, Swedish developer Niklas Zennstrom had co-developed a "disaggregated" file-trading network called FasTrack. The indexes that enabled FasTrack's users to find one another's files were not stored on Zennstrom's own servers, the way Napster's had been. Instead they were strewn across the network, temporarily stored on thousands of users' own PCs. (The software automatically determines which users' computers are suitable for this purpose and reassigns the indexing function to new computers as users go on-and offline.) Zennstrom then co-founded Kazaa BV, a Dutch company, and set up a website from which users could download the Kazaa Media Desktop, which would enable them to navigate the FasTrack network. Kazaa also licensed aspects of its FasTrack source code to other services, including Morpheus and Grokster. These licensees, in turn, developed their own distinctive desktop applications for tooling around the FasTrack network. Grokster pays Kazaa 60% of its revenues for its license.

All of these licensees could plausibly maintain that they were not services, like Napster, but rather mere "providers of software tools." Those tools simply enabled customers to explore the preexisting FasTrack network, which the licensees had not created, and which they did not control.

Moreover, even Kazaa itself might be able to advance much the same defense. Though Kazaa started the network, it had subsequently become simply one of many providers of software tools for traversing it. The network was "self-organizing" and would persist, it was said, even if Kazaa and all its licensees were to disappear from the scene.

Then, one fateful day in late February 2002, Kazaa froze Morpheus's users out of the FasTrack network. Lawyers' eyebrows were raised. The FasTrack network was apparently more centralized than had been thought. They sought to scrutinize the FasTrack software and see whether there was a man behind the curtain somewhere who could turn the whole thing on and off like a spigot.

Good luck. Three months after being sued in Los Angeles by the entertainment industry, Zennstrom sold the Kazaa name and most of its assets to a British woman named Nikki Hemming, who financed her purchase with a loan from Zennstrom. She then started two companies. One, called Sharman Networks, is organized under the laws of the Pacific island nation of Vanuatu and appears to have no employees. The other is an Australian company called LEF Interactive (for liberte, egalite, fraternite), which supplies the staff for Sharman.

The movie studios then sued Sharman and LEF, each of which claimed it was beyond the jurisdiction of the U.S. court. Hemming's companies lost those arguments in January 2003. But it turned out that neither of them had the FasTrack source code anyway. Though Zennstrom had sold most of Kazaa's assets, he kept the source code, which now belongs to his new Swedish company, Joltid. Sharman licenses the FasTrack code, in exchange for 20% of its revenues, from Joltid. Joltid has operations in Estonia and the Channel Islands off the English coast, and that's whose legal authorities the entertainment industry lawyers are dealing with now to try to get their hands on the FasTrack source code.

Even if the studios find the source code, their problems won't be solved. Regardless of how tightly controlled aspects of the FasTrack network might turn out to be, there is at least one file-sharing network out there that is uncompromisingly self-organizing and decentralized. The Gnutella network, whose key software is open source, was created as a noncommercial labor of love. It requires minimal maintenance, which is provided by volunteers.

Though Gnutella's creation was noncommercial, several for-profit outfits--don't call them services, remember!--now sell proprietary, advertising-supported software that enables users to navigate the Gnutella network. These include LimeWire, BearShare, and--ever since it got kicked off FasTrack--Morpheus. Although the Gnutella network is currently an order of magnitude less popular than FasTrack, it might be able to absorb the FasTrack audience if FasTrack were ever driven under.

To be sure, even the Gnutella-based file-sharing companies retain some traits of services. Morpheus, for instance, periodically contacts the servers of its owner, StreamCast Networks, to fine-tune the software. "But it has no ability to control what people search for ... and no ability to know what they have downloaded," emphasizes the EFF's von Lohmann, who now represents StreamCast in the litigation. That's the crucial question, he maintains.

Von Lohmann may be right about that. After all, lots of products are sold under customer-service contracts whereby manufacturers maintain some relationship with their customers. Some hardware products like TiVo are even sold on a subscription basis. The whole product-service distinction is getting murkier by the minute. Why should legality or illegality hinge on such an ethereal distinction?

The Napster court had ruled that Napster, because it kept its indexes on premises, could filter out copyrighted works without fundamentally altering its "current architecture." That's precisely what neither the FasTrack nor the Gnutella-based systems can do, von Lohmann argues, because of their decentralization.

On April 25, 2003, U.S. District Judge Stephen Wilson ruled that von Lohmann was right. Morpheus and Grokster were protected from liability by the Sony Betamax ruling, as interpreted by the Napster court, he decided. (The legality of Kazaa itself has not yet been ruled upon.) Nevertheless, Judge Wilson agreed with the many judges before him who had already ruled that users of file-sharing services do engage in copyright infringement when they upload or download copyrighted files. His ruling produced the anomalous situation we see today, in which users of file-sharing services can be sued, yet commercial operators can't be. It's as if individual cocaine addicts could be prosecuted, while the Cali cartel was beyond reproach. (Again, not to sound judgmental.)

The entertainment industry has appealed Judge Wilson's ruling, and the U.S. Court of Appeals in San Francisco will likely hear the case this winter.

Two months after Judge Wilson's ruling, the entertainment industry got better news from a federal appeals court in Chicago. In affirming the shutdown of a different file-sharing service called Aimster, Judge Richard Posner interpreted the Betamax formula very differently. His approach would allow courts to bar services and products that are overwhelmingly used for infringement, even if they are also capable of noninfringing uses. If the appeals court in San Francisco upholds Judge Wilson's Grokster ruling, there will be an arguable conflict among the federal appeals courts, and the stage might be set for the U.S. Supreme Court to take the case and revisit the Betamax precedent.

Many people today have come think of the Betamax case as a parable of Hollywood shortsightedness. They claim that the studios, unduly fearful of new technologies, tried to strangle the VCR in its cradle, nearly asphyxiating the home-video market that proved so lucrative later on. Moral: If the entertainment industry simply embraces the new file-sharing technology, it will end up making more money than ever before.

That picture is distorted. If the Betamax ruling had come out the other way, VCRs would never have been stamped out. Rather, a system of royalties would have been imposed, either by statute or negotiation or court order, with a portion of the manufacturers' revenues going into a pool for artists. That is how copyright holders are compensated for "private" copying in some 42 countries today, including 12 of the 15 European Union nations.

In fact, we have covered so much cultural ground since 1984 that it is startling to recall what was really at stake in the Betamax case. The case was not filed over the studios' concern that someone might use a VCR to distribute copyrighted works to other people--which is what file sharing is all about. Trying to distribute movies with an analog VCR would have been clumsy, slow, and expensive. Strange as it sounds, the studios were complaining then about only two activities: the building of home libraries of movies taped from free television, and "time-shifting"--taping a TV show so that you could view it once, at a more convenient time, and then erase it. The court's 5-4 majority ultimately decided that "time shifting" required no compensation of artists at all, in part because it "merely enables a viewer to see such a work which he had [already] been invited to witness in its entirety free of charge.... The time shifter no more steals the program by watching it once than does the live viewer."

Incredibly, this cautious holding is the one that is now thought to immunize commercial file-sharing services from liability, though their primary use is to enable millions of people to obtain free copies of copyrighted works from total strangers, most of whom have never paid to acquire those works either.

Why did the studios ever think they might be entitled to compensation for consumers' personal use of their works within the home? Try looking at it this way. What entices people into stores to buy VCRs is, in part, the prospect of taping copyrighted shows. If so, why should equipment manufacturers hoard all the profits, rather than sharing them with the copyright holders?

As crazy as that view may seem to Americans today, four of the nine justices agreed with it in 1984. That view, again, still prevails in most of Western Europe today.

The notion that copyright holders might be entitled to any degree of control over the technologies that purvey their works now seems quite foreign to American ears--and certainly unnecessary in the VCR context. But it is the conspicuously missing ingredient in discussions of file sharing. The value of today's commercial P2P technologies stems almost entirely from copyrighted works, yet copyright holders have lost any say in how those technologies can be used.

Is it fair, I asked Grokster attorney Michael Page, that Grokster is making money by advertising to crowds who are drawn almost exclusively by the prospect of obtaining copyrighted works--yet copyright holders see none of those revenues?

"The short answer is, that's just not the way the law works," he accurately responds. "Is it fair that so much of the income of broadband providers comes from people copying files?" He is referring to the fact that broadband providers like Verizon and SBC have, with varying degrees of blatancy, used the attractions of file sharing as a means of selling their services. "Download all the music you like," urged one notorious SBC ad for DSL service. "Sure beats going to the record store."

"Fair or unfair, it's legal," says Page.

For the moment, he's right.