The government and Microsoft have failed to settle their landmark antitrust case before the first deadline imposed by a federal judge, sources said on Friday. The two sides also appear to have been unable to agree on a mediator for the remaining discussions, indicating that a deep gulf of differences may separate the parties. Lawyers representing Microsoft, the Justice Department and 18 states delivered the news in a conference call Friday with US District Judge Colleen Kollar-Kotelly, said sources familiar with the call. If the parties did not submit a mediator for the judge's approval, she could assign one or allow the process to continue without third-party oversight. Representatives for the states and Microsoft confirmed that a phone call took place but declined to share any details. As settlement negotiations move closer to a court-imposed 2 November deadline, the introduction of a mediator could intensify talks that Kollar-Kotelly has previously said should proceed "24 hours a day, seven days a week". But whether the sides can settle may hinge on what changes Microsoft is willing to make to its new operating system, Windows XP. Earlier settlement talks mediated by Judge Richard Posner collapsed on April Fools' Day 2000, in part because some states wanted to push hard for breaking up Microsoft, said sources close to both sides of the negotiation. But the joke may have been on the states, which saw a federal appeals court in June throw out the breakup remedy imposed by Kollar-Kotelly's predecessor, US District Judge Thomas Penfield Jackson. In a move that surprised some legal experts, the Justice Department last month took a breakup off the table, in a gesture seen as a move toward settlement. But the distance separating the two sides remains great, with the states once again potentially playing the pivotal role in determining the outcome, legal experts warn. The issue: Windows XP. Many legal experts also question whether a new mediator could do any better than Posner, who heads the US Court of Appeals for the 7th Circuit in Chicago. "The most well-respected, most vigorous appellate judge in the antitrust realm couldn't even bring them close to settlement," said Glenn Manishin, an antitrust lawyer with Kelley Drye & Warren in Vienna, Virginia. "The same dynamics that imperilled the mediation last year under Judge Posner are going to create fundamental difficulties in bringing the parties together on common ground." Jackson called on Posner to be a mediator because of what he called "divergent views" dividing the government camp. Although the reasons for division may be different, some states may be looking for more than what the Justice Department is seeking. The attorneys general for California and New York, for example, issued a statement last month saying they would pursue their cases independently should the Justice Department settle on too easy terms. With a breakup out of the picture, however, the chances for settlement are better now than at any other time in more than a year and a half, say legal experts. "This mediation has a much greater shot of resolving this case than the prior one," said Hillard Sterling, an antitrust lawyer with Gordon & Glickson in Chicago. "The administration is much more receptive to a negotiated resolution. The real trick for the Bush team is to get the states to fall in line." Sterling added that the negotiations are "going to be tough, but the states don't appear to be as firm and steadfast as they previously were. At the least, they must admit that structural relief is clearly off the table. That's a significant change from the previous environment that made settlement virtually impossible." The states have voiced continuing concerns about Windows XP and Microsoft's bundling of new technologies, such as streaming video and instant messaging, which could disrupt or hamper competition in other markets. The European Union's competition commission raised similar concerns and, in late August, expanded its Microsoft investigation to include media playback technology bundled with Windows. "XP also is a huge issue in the United States as well," Sterling said. "I think the states are definitely going to try and tread in those waters. The states will probably insist on a change to XP." Microsoft has vigorously resisted every effort to expand the scope of the case beyond Internet Explorer or Windows 95 and 98. But Jonathan Jacobson, an antitrust lawyer with Akin, Gump, Strauss, Hauer & Feld in New York, doesn't see any way to exclude Windows XP. One reason: Antitrust remedies, whether negotiated or imposed, tend to be forward looking. "Whatever relief is ultimately entered will have to be entered into the context of Windows XP or whatever operating system is out there at the time," he said. At one point, the government appeared to be considering whether to seek an injunction against Windows XP's official launch on 25 October. But Microsoft's legal tactics of delay made that nearly impossible, Jacobson said. "Microsoft has cleverly gotten ahead of the game in this regard," he added, "but it's likely going to have to make some modifications to XP as the process goes on." Sources close to the government said trustbusters backed off an injunction in part because they believed Microsoft could use Windows XP's update feature to make changes to the operating system at a later time. Legal experts said the blueprint for the current negotiations will come from previous failed talks and the original remedy issued by Jackson in June 2000. The government wants to use Jackson's remedy as a starting point, something Microsoft strenuously objected to before Kollar-Kotelly. She rejected Microsoft's argument. The biggest question hanging over settlement discussions will be to what extent restrictions should go beyond Windows. Here, Microsoft's resistance to restrictions on what it can bundle into Windows could derail any prospect of settlement, Manishin predicted. "The big thing they were divided on (in previous negotiations) was a technical term called 'communication interfaces,'" he said. "Communication interfaces connect to Windows machines and non-Windows machines--any other kind of computer, servers, handhelds, phones, etc. That's where Microsoft was unwilling to compromise." Restrictions in this area could greatly impede a number of well-developed or forthcoming Microsoft strategies, such as selling software as a service. In fact, Microsoft revealed earlier this week that on the day of XP's launch later this month, the operating system's messaging client will be updated to receive the first piece of the company's .Net software-as-a-service initiative. "The second thing (the previous) negotiations revealed is that the government was searching for a way to decide when technological integration--what the Court of Appeals called commingling of code--was bad," Manishin said. In its June ruling, the Court of Appeals found that Microsoft's commingling of Internet Explorer and Windows 95 and 98 software code hampered competition from Netscape Communications, which is now owned by AOL Time Warner. That ruling, in some respects, surprised some legal experts, who hadn't expected the court to rule in favour of issues affecting software design. Now with the force of the appeals court behind it, the government is likely to revisit this issue, even though it contributed to the demise of earlier negotiations, Manishin said. Ultimately, Jacobson said, "Microsoft has or thinks it has more to gain by objecting and delaying rather than sitting down and entering into a meaningful settlement that would accommodate the legitimate interests of the government or the states." He predicts a long, drawn-out process, which would commence in December if there is no settlement. Remedy hearings are set to start in March. Still, Microsoft's trouble overseas could give the company reason to push hard for a settlement in the United States. The European Commission's investigation could lead to a whopping $2.5bn (£1.7bn) fine, or 10 percent of Microsoft's annual revenue. "The European Commission could go much further in getting a remedy than would be issued in the proceedings in Washington," Jacobson said. "They have an open book to look at. They can look at Office, which clearly is not a part, at least at this stage, in the proceedings in Washington." While the US case focused on the desktop, the ever-expanding European investigation is looking at how Microsoft used Windows on the desktop to sell server products. European trustbusters, unlike their US counterparts, will look as much at the effect on competitors as on consumers. "Microsoft clearly has another huge battle on its hands in Europe," Sterling said. "But a successful resolution here would spark hope of a decent result in Europe. European regulators would favourably view a negotiated settlement in the United States." Jacobson disagreed that a US resolution would necessarily help Microsoft in Europe. "It depends on what the settlement is," he said. "The GE-Honeywell circumstance told us that the Europeans are going to do their thing, regardless of what happens in the US." In a surprise move in July, the European Commission rejected the merger between General Electric and Honeywell. In the United States, the Justice Department had approved the union. See the DoJ/Microsoft News Section for the latest headlines. See the Business News Section for full coverage. Have your say instantly, and see what others have said. Click on the TalkBack button and go to the Microsoft forum. Let the editors know what you think in the Mailroom. And read other letters.