Yahoo’s board has met 20 times in recent months to consider options, including Microsoft’s bid. The top managers of Yahoo and Microsoft met face-to-face seven times, the letter said.

But Icahn left the door open for a settlement instead of a full-out proxy battle where both sides typically spend millions of dollars and unleash a barrage of attacks on each other. Icahn urged Yahoo to "move expeditiously to negotiate a merger with Microsoft, thereby making a proxy fight unnecessary."

The New York-based billionaire’s move garnered public support from at least one other large investor. Paulson & Co, a $30 billion hedge fund that raked in billions of dollars betting on the credit meltdown, disclosed on Thursday that it had amassed a 3.4 percent Yahoo stake worth $1.44 billion.

"We intend to support the Icahn slate, but sincerely hope Yahoo will negotiate an agreement with Microsoft, thereby making a proxy fight unnecessary," said Paulson.

Microsoft spokesman Frank Shaw declined to comment on Icahn’s move and reiterated the line Microsoft has used since talks with Yahoo ended. "The company has moved on," he said.

Microsoft walked away after negotiating for three months in hopes of clinching a deal to form a counterweight in Web search and online advertising to market leader Google .

Microsoft’s final $33-per-share offer wasn’t enough to sway Yahoo co-founder and Chief Executive Jerry Yang, who wanted $37 a share. The stock traded around $19 prior to Microsoft’s bid.

On Thursday, Yahoo shares closed up 2.3 percent at $27.75, while Microsoft rose 1.7 percent to $30.45, both on Nasdaq.

ROUGH ROAD FOR YANG

Industry watchers said Yang faces a rougher road dealing with Icahn, a blunt-spoken financier known for bare-knuckle takeover tactics, than with Microsoft CEO Steve Ballmer.

"If Jerry Yang had a tough time dealing with Steve, wait till he meets Carl Icahn," said Colin Gillis, a Canaccord Adams analyst.

A bigger threat, said Gillis, will be if Microsoft is unwilling to come back to the table. "It’s not clear that he has a buyer. We think that Microsoft has really walked away."

Others said there is a reasonable chance of revived talks, arguing that the strategic rationale for Microsoft’s initial interest in Yahoo hasn’t changed in the last two weeks.

The proxy contest gives new wind to annoyed shareholders who felt Yang overplayed his hand in turning down Microsoft’s $33 per share offer, holding out for a higher price.

"We view this as a very positive development," said a portfolio manager at a large investment firm that holds Yahoo shares. "Getting some new blood on the board would be very beneficial."

’WIN-WIN’ FOR HOLDERS

Icahn said he sought clearance from the U.S. Federal Trade Commission to buy up to about $2.5 billion in Yahoo stock. In a regulatory filing, he said he now holds 4.3 percent, including 9.9 million shares and 49 million call options.

One analyst said things are now looking up for Yahoo stockholders. Shares jumped from $19.18 prior to Microsoft’s initial $31-per-share bid to nearly $30 in early February, only to dive to about $24 when talks collapsed on May 3.

"Barring procedural objections, (Yahoo investors) are now in an almost win-win situation," Sanford C. Bernstein analyst Jeffrey Lindsay wrote in a note.

"Either the existing Yahoo management team now proposes an alternative -- most likely a paid search outsourcing deal with Google. Or the Icahn slate gets elected and reopens negotiations to sell the company to Microsoft," Lindsay said. "Icahn’s bid now forces the issue."

Icahn’s slate of nominees includes himself, Frank Biondi, a former Viacom chief, and Keith Meister, vice chairman of Icahn Enterprises .

Mark Cuban, owner of the Dallas Mavericks professional basketball team and co-founder of cable network HDNet, is also on Icahn’s slate. Cuban struck it rich after he sold Broadcast.com to Yahoo in 1999 for about $5 billion.

Other nominees include Harvard corporate governance expert Lucian Bebchuk; John Chapple, former CEO of Nextel Partners; Adam Dell, a venture capitalist and brother of computer tycoon Michael Dell; Edward Meyer, former CEO of advertising firm Grey Global Group; hedge fund manager Brian Posner; and Robert Shaye, former co-CEO of Time Warner’s New Line Cinema.

(Reporting by Kenneth Li and Michele Gershberg in New York, Eric Auchard in San Francisco, Svea Herbst-Bayliss in Boston and Diane Bartz in Washington, D.C.; Editing by Jeffrey Benkoe and Braden Reddall)