Microsoft and Yahoo, which were on the brink of a hostile takeover battle earlier this week, are now discussing a friendly merger that would involve more money for Yahoo shareholders.
But talks are at a sensitive stage and a deal is not certain, added the person, who was not authorized to speak publicly on the talks.
Microsoft has reluctantly agreed to raise its stock and cash offer of $31 a share for Yahoo to about $33, though Yahoo is holding out for $37, sources have told CNBC. The current bid is worth about $42.4 billion.
The dicussions have heated up despite Microsoft Chief Executive Steve Ballmer's comment on Thursday that walking away from a deal with Yahoo was one of three options the company is weighing.
The Wall Street Journal also has reported that Microsoft appeared to be leaning toward initiating a hostile takeover of Yahoo.
Microsoft has promised this would be the week that it spells out its next moves if Yahoo allowed a deadline set for last Saturday to expire on its three-month-old offer to buy Yahoo.
But in a sign that Yahoo continues to resist Microsoft's embrace, a source familiar with discussions between Yahoo and Google said a partnership could come as early as next week. The non-exclusive partnership would involve Yahoo carrying Google advertising alongside Yahoo's Web search results.
Despite Friday's developments, Yahoo is still holding talks with other potential partners about an alternative to Microsoft's
Yahoo has held discussions with Time Warner's AOL Internet division and News Corp.
Ballmer: Yahoo 'Part' of a Strategy
Ballmer told employees during a regularly scheduled company Town Hall meeting that Yahoo is valuable as part of a strategy to beat Microsoft arch-rival Google, but there are limits on the price Microsoft is ready to pay.
"Yahoo's not a strategy, it's a part of a strategy," Ballmer declared. His remarks were first reported by Silicon Alley Insider, whose reporter said he monitored the internal conference call. A company spokesman confirmed the comments.
"We're interested to pay for it at some level and beyond that level we're not willing to pay for it. I know exactly what Yahoo is worth to me ... I won't go a dime above and I will go to what I think it's worth if that gets the deal done," he said.
(See CNBC's report on the latest Microsoft-Yahoo developments at left.)
Seeking to force Yahoo to the negotiating table in early April, Ballmer wrote a letter to Yahoo's board of directors threatening to cut the bid and mount a proxy fight to remove the board if Yahoo did not reach a deal by April 26.
Ballmer went further last week by saying Microsoft was considering walking away from the deal. But most Wall Street analysts dismiss this as a hardball negotiating tactic rather than a real threat to end its two-year-long pursuit of a deal.
On Thursday, five days after Microsoft's deadline for reaching a negotiated deal expired, Ballmer told employees "we ought to announce something in very short order."
"We've got basically the three big options in front of us," Ballmer summarized. "There's the friendly deal, there's an unfriendly deal, (and the) third path is simply to walk away."
The two companies are in a standoff over price. Yahoo responded within weeks of receiving the unsolicited takeover bid by saying the offer "substantially undervalues" it. It has sought other partners, while not ruling out a Microsoft deal.
The Wall Street Journal reported on Wednesday that Microsoft had told Yahoo it was willing to raise its bid to as much as $33 a share, but was unwilling to go as high as the $35 to $37 a share for which Yahoo's major investors have lobbied.
Ballmer repeated the key reasons for buying Yahoo were that it would allow Microsoft to move faster in creating a credible No. 2 to Google, which dominates key segments of the Internet market and is expanding rapidly in new directions.
Yahoo would provide Microsoft scale, a bigger audience for Web search — a key starting point for many Internet users — and a stronger presence in online advertising, he said. "The world is rooting for us," Ballmer said. "The world hopes that there's ... a very strong company that's not the number one guy," he said, referring to Google.
Most Wall Street analysts believe Microsoft's most likely next move is to begin a months-long proxy campaign, according to a Reuters poll conducted late last week. Analysts believe Microsoft will win but at great cost to Yahoo employee morale.
- Reuters contributed to this report.