Shares in the search giant, the second most popular in the world, jumped 54 per cent after the proposal from Microsoft. The deal was seen by analysts as an attempt by Bill Gates to take on Google, which dominates internet searches.
While Google has 58 per cent of the global market, Yahoo has seen its share fall to 23 per cent.
If the deal succeeds, it would create the world's biggest internet company.
"Search is the most important part of the market," said Justin Pearse, editor of New Media Age. "Microsoft and Yahoo can't sit back and let Google just take all the money. By combining with Yahoo, Microsoft will have a better chance of challenging Google."
It is known that Mr Gates, the world's richest man, has become increasingly concerned over Microsoft's failure to mount an effective challenge to its rival in this lucrative area.
The deal, a mixture of cash and shares, will raise fears that Microsoft could increase its stranglehold on the technology industry. The company supplies much of the software for the world's computers and has its own MSN search engine and the popular Hotmail email service.
Microsoft's $31-a-share offer is 62 per cent higher than last night's closing price.
On Tuesday, Yahoo chief executive Jerry Yang said that it would lay off up to 1,000 staff as it faced "headwinds" this year and announced a profit fall of 23 per cent.
It emerged today that Yahoo rejected a bid from Microsoft a year ago, raising the possibility there could now be a battle for control of the search engine.
In a letter released today, Microsoft CEO Steve Ballmer wrote to the Yahoo board: "While a commercial partnership may have made sense at one time, Microsoft believes that the only alternative now is the combination of Microsoft and Yahoo that we are proposing. This proposal represents compelling value realisation event for your shareholders."
Yahoo's days as an independent company appear to be over. Rupert Murdoch's News Corporation also held talks about taking a stake in Yahoo last June.
"This offer was inevitable given that Google has risen so quickly and powerfully," said Mr Pearse, editor of New Media Age.
"Yahoo launched a new search service called Panama last year while Microsoft launched its own search service AdCentre - and both are not doing very well."
Bryan Glick, a technology expert, said Microsoft was attracted toYahoo because it has "a big user base, a great brand name and a lot of good (technology) engineers. It brings a lot of research and development talent into one place".
Georges Yared, investment strategist at Yared Investment Research in Minneapolis, said: "If you were to combine these two, they would be a formidable second player."
The software giant insisted today that its proposed takeover would not fall foul of US regulatory authorities. It expects to make $1 billion in cost savings.
Mr Gates has now stepped back from running the firm, which has faced a string of competition investigations in America and Europe. Searches are the most lucrative way to generate advertising on the web. Paid-for searches accounted for more than 55 per cent of the £2 billion online advertising market in Britain 2007.
When News Corporation held talks about taking a stake in Yahoo in June 2007, the proposed offer valued the firm at around $37 billion. Shares in Yahoo had fallen 18 per cent since the start of January until Microsoft's offer today.
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