Mr Gates said he would stay on as chairman of the company's board and dedicate himself to work on Microsoft's software development.

Mr Gates said he was handing over to his longtime friend Steve Ballmer so that he could return "to what I love most - focusing on technologies for the future".

The move comes at a delicate time for Microsoft, which is facing the threat of a break-up as a result of an anti-trust suit by the US government.

Chief software architect

Adding to the title of chairman, Mr Gates will now also be known as Microsoft's "chief software architect".

He said he wanted to help drive "the next generation Windows internet platform and services".

He served as chief executive of Microsoft since he co-founded it 25 years ago.

However, the announcement does not necessarily mean that Mr Gates is giving up any power in the Seattle-based software giant.

He is bound to continue having a huge influence on setting Microsoft's strategy.

Addressing Microsoft's troubles

The handover of power comes at a crucial moment for the company, as it faces the US government in a long and bitter antitrust trial over alleged anti-competitive behaviour.

There have been suggestions that Microsoft might be broken up into several companies.

Speaking after his appointment, Mr Ballmer immediately joined the fray saying it would be "reckless" and "irresponsible" to break up the company.

Technological future

Both Mr Gates and Mr Ballmer described the 1990s as the "software decade" and said they wanted to make sure that Microsoft could build on its successes.

The firm's new "chief software architect" said the company was trying to find a management structure that would allow it to revolutionise the company's software products.

He said that by "getting all our management team and resources grouped around the software strategy", the company could defend its position in the industry.

In a statement, the company said that "the first internet-based platform of Next Generation Windows Services" would be at the core of Microsoft's strategy.

New products and services would "incorporate such features and capabilities as a new user interface, natural language processing, application development approach", and a new file system.

Mr Ballmer said he was "very excited" to take over at these "amazing times full of remarkable opportunities".

He insisted that the company would stay tightly focused on software and predicted there would be no mega-mergers for his firm.

Mr Gates supported this view, saying that "it's not on our agenda to go out and buy a big content company", an allusion to the merger of America Online and Time Warner earlier this week.