• by Laurie Sullivan , Staff Writer @lauriesullivan, March 1, 2010

Google finds itself ensnared in a web of Stalinist history, human rights and international cyber sabotage. Is a pullout imminent?

Some call it modern day espionage, while others refer to it as information warfare. It doesn't matter what you call it, but imagine an attack that infiltrates defense systems to shut down operations from a variety of U.S. businesses, such as electrical power facilities and banks.

Cyber threats have become one of the most serious economic and national security challenges the United States faces. And while the cyber attack on Google's infrastructure didn't shut down the search engine, hackers did manage to access the Gmail accounts of human rights activists in China.

Adobe, Symantec, Microsoft and Yahoo were among the more than 20 U.S. companies involved in the cyber attack that had Google threatening to leave China, and supporters leaving flowers in front of its Bejing headquarters. Reports suggest that the incident led Google to partner with the National Security Agency (NSA), asking for assistance to investigate the attack.

The official line from Chinese officials dismisses accusations that the government and the military had been involved in cyber crimes. But in late February the attacks were traced to two schools in China - Shanghai Jiaotong University and the Lanxiang Vocational School - which reportedly have ties to Baidu and the Chinese military.

Google had threatened to shutdown google.cn, but not advertising services, after the cyber attacks. The Mountain View, Calif., company no longer wanted to adhere to an agreement with the Chinese government to censor search results. Sources couldn't confirm the extent of the negotiations between Google and the Chinese government, only that talks had begun.

Google vice president Alan Eustace said on Jan. 19, that Google would retain its China research and development center, and may continue some of its Chinese business, even if negotiations with the Chinese government regarding censoring search results turn sour.

Charles Burton, professor in the department of political science at Brock University in St. Catharines, Ontario, Canada, says it has become difficult, at best, to negotiate with the Chinese officials, because the government "consistently deny they engage in any type of hacking into foreign computer networks despite compelling evidence to the contrary of foreign governments and intelligence departments."

Through years spent working in China as a diplomat Burton became familiar with the country and settled part-time in a home near the Laos-Vietnam border. He says Chinese residents respect Google, but many of the online tools, from Blogspot to YouTube, are not available. China's basic Stalinist nature hasn't changed since the communist government took power in 1949. "Political blog posts often just disappear," says Burton.

Google met with its large advertisers in China, and key resellers and agencies to send the message that things were "business as usual," according to T.R. Harrington, co-founder and chief executive officer at Darwin Marketing, Shanghai, China. "I don't feel any more comforted about the situation," he says. "I'm not buying that message ... it doesn't feel right."

Harrington says the implications of Google pulling completely out of China will affect the content network most. He estimates that globally, Google garners between 40 percent and 60 percent of its revenue from AdSense, the content network ads that show up on blogs and other Web sites.

While all of the local portals in China - Sina, Sohu, NetEase and TenCent - have their own search engines, Harrington doesn't believe any have a reliable content ad network. Both Microsoft and Yahoo have a slight presence in the Chinese market.

If google.cn leaves China, Baidu remains the local search engine with the strongest content ad network. While Baidu generates a small percentage of revenue from its content network, Harrington expects the Chinese search engine would attract the majority of the premium publishers who would no longer have an option to generate revenue from Google.

In mid-February, Baidu reported revenue above expectations for the fourth quarter of 2009, along with Q110 guidance. The company guided March revenue to $178 million, above the Street at $170 million.

Baidu, of course, stands to benefit the most should Google pull up stakes. Piper Jaffray analyst Gene Munster wrote in a research note that Baidu management mentioned the Q1 guidance does not factor in the potential revenue that would result from Google shutting down its search business. Munster estimates if Google.cn closes soon, it will add between $67 million and $100 million to Baidu's calendar year revenue.

It appears that Baidu's content ad network and ad tools, Phoenix Nest, took off better than expected. While the December quarter revenue was negatively impacted by the transition to the platform, the magnitude of the impact was smaller than feared. Munster believes the transition is behind Baidu by the first quarter, but the company admits the learning curve remains steep for advertisers, which implies the second quarter has room for continued improvement as advertisers gain comfort with the new system.

Matthew McDougall, chief executive officer and executive chairman at SinoTech Group, which has offices in Beijing, Shanghai and Hong Kong, calls it a delicate situation. "Clearly you lose a piece of your soul when you capitulate to that level, but maybe you're prepared to do it when the times are good," he says. "This, however, is not only about capitulation, but a severe attack on Google's servers and systems. It's a dangerous thing to accuse the Chinese government of this type of thing."

Google has made massive investments in protecting its infrastructure against sabotage from support countries, such as China. Conspiracy theorists suggest the scenario puts the last 30 percent of the Chinese searchmarket, which Google holds, back into Baidu's hands.

This means Baidu retains about 90 percent share of the Chinese search engine market. Companies are expected to spend about $2 billion on search, display and rich media ads in China, according to some estimates.

Execs at local marketing agencies are holding their breath, sitting on the sidelines, before making a move. Most wait for Google to exhale first.