Microsoft's Bing will now power Yahoo search, while Yahoo will use its solid relationship with advertisers to become the "salesforce' for both companies" search advertisers, the firm said.
The companies claimed that the deal will accelerate innovation in search, and make Bing-powered search more personally relevant to users because of its increased advertising strength.
"Advertisers will also benefit from scale and enjoy greater ease of use and efficiencies working with a single platform and sales team for premium advertisers," said Yahoo chief executive Carol Bartz.
Bartz added that Microsoft's expertise would let Yahoo concentrate its growth in the priority areas of display advertising capabilities and mobile experiences.
Meanwhile, Microsoft chief executive Steve Ballmer said that the partnership would provide the scale and resources Bing needs to be competitive.
The partnership will be exclusive for 10 years, but Bartz insisted that there is no exclusivity if Yahoo chooses to use Microsoft technologies in its mobile products.
Both companies will maintain their own separate display advertising businesses and sales teams, and will continue to compete with each other in all areas not related to search.
Yahoo will continue to own the user experience on Yahoo search with its brand name remaining, Bartz clarified, adding that the only visual change for web users will be at the bottom of the page, which will read "powered by Bing".
When it comes to the financial terms of the deal, Microsoft will pay traffic acquisition costs to Yahoo at an annual rate of 88 per cent of search revenue generated on Yahoo sites during the first five years of the agreement.
As a safeguard, Microsoft has also promised to guarantee Yahoo generated revenue, although only for two years.
Bartz said that Yahoo would not be paid any lump sum in cash for the partnership, and Yahoo stock fell more than 10 per cent immediately after the deal was announced.
However, Yahoo estimates that the agreement will increase its revenue by approximately $500m (£305m) per annum.
Bartz said that the deal would be closed by early 2010, following regulatory approval. The full implementation of the partnership will then occur in the following 24 months.
Some Yahoo employees will be asked to take jobs at Microsoft, while other staff will be made redundant. Bartz could not comment on the number she expected to lay off.