Microsoft is going to pay $1.95 billion to get Sun Microsystems, the company with the sharpest spurs, off its back.

The pair said this morning that they had settled all their legal differences. Microsoft will pay Sun $700 million to resolve antitrust issues, $900 million to resolve patent issues and a $350 million up-front down payment on a 10-year cross-license that includes Java and .NET. Sun will pay Microsoft when the technology gets into its servers.

The $1.6 billion payment is more than people thought it would take to settle the Sun litigation - heck, Microsoft only paid AOL Time Warner $750 million for Netscape and Netscape is D-E-A-D dead. Sun had only put a value of $1 billion on its suit.

But it's a good investment. Microsoft is paying Sun to withdraw its long-running antitrust complaints to the European Commission, which were a big factor in the EC finding against Microsoft last week. And the EC's spurs threaten to draw blood from Microsoft's flanks.

The fact that Sun persuaded the EC to order Microsoft to share more of its Windows secrets is not as dangerous to Microsoft's fundamental business as is the fact that the regulators were persuaded to order Microsoft to offer two versions of Windows in Europe, one of them stripped of the Windows Media Player, and reserve for themselves the right to challenge any future bundling by Microsoft.

The new kissy-kissy 10-year collaboration accord between Sun and Microsoft, however, will force the EC to reconsider its position and modify its ruling, softening it up to come to terms on tying. Bo Vesterdorf, the president of the EU appeals court where Microsoft is headed next, is also making noises about trying to broker a compromise.

Microsoft CEO Steve Ballmer denied that there was any connection between the settlement and the state of things in Europe. The companies were close to a deal at Christmas, he said, and were delayed by the fact that Microsoft's top lawyers, who were working out the Sun deal, had to camp out on the EC's doorsteps.

Ballmer and Sun CEO Scott McNealy appeared together on CNBC this morning beaming at each other, shaking hands and talking up their newfound "unique" and "exceptional" interoperability and compatibility. They ever exchanged signed Detroit Red Wings jersey later at the press conference.

Among other things, Sun is now going to certify Windows on its Opteron and Intel servers that otherwise run Solaris x86 and Linux.

The fact that they had signed their treaty at 4 o'clock this morning was a godsend for McNealy, because it stopped Sun's stock from going through the floor. It turned it around and at mid-day Sun was trading up about 19% to $4.97.

See, news of the pact followed immediately on the heels of Sun's admission that its third fiscal quarter, which closed on Wednesday, was a disaster and that it would lose between $750 million and $810 million. That would work out to 23-25 cents a share when Wall Street was braced for a loss of only three cents. Revenues are coming up short at around $2.65 billion.

The shortfall in both earning and revenues - Sun is getting slaughtered at the low end where it gets the bulk of its sales by Linux and Windows - is forcing Sun to cut another 9% of its workforce, roughly 3,300.

McNealy, who has been obsessed to the point of neurosis by Microsoft for years and has been personally overextended since president and COO Ed Zander stepped down, has tapped Sun software chief Jonathan Schwatz to fill Zander's size 13 shoes.

Schwartz gets everything except HR, corporate resources and finance. The CTO will report to Schwartz. Sun said it will name a replacement for Schwarz soon.

The layoffs - and Wall Street has been telling McNealy that he didn't cut deeply enough when he fired people before - will cost Sun roughly $475 million in charges over the next few quarters. McNealy indicated terminations would start worldwide in the next five or six weeks.

McNealy took credit for initiating the talks last June when he called Ballmer and invited him to play golf. (The two men went to high school, Harvard and Stanford together and have been known to hit a little ball around the fairways together before.) One thing led to another and they exchanged legal teams and have had Bill Gates and Sun CTO Greg Papadopoulos talking on a regular basis for months now.

McNealy said he was pressured to try glasnost by his customers, who have mixed environments and wanted the companies to "stop the noise" and "get it together." Ballmer said there was "nothing, nothing, nothing, nothing" in the agreement, which was barely sketched, that "would not delight" both sets of customers.

Ballmer and McNealy said the agreement contained an "IP framework" or "patent regime" that would assure them of protection going both "forward and backward" and prevent the two companies from fouling up their collaboration.

Merrill Lynch called the Sun layoffs "directionally correct," and said it viewed Schwartz's promotion as a "positive step," but it said Sun's 1Q pre-announcement still shows operating performance is deteriorating, and the cost structure is unsustainable." Sun is also proposing to dispose of more of its real estate.

Microsoft's money will raise what Sun has in the bank to around $7 billion and McNealy indicated he would flash his bank book around in hopes of getting the rating services to upgrade Sun from junk.

For its part, Microsoft still has other private antitrust and patent infringement suits to resolve such as the one brought by burst.com and potentially whopping big one by InterTrust Technologies, now a property of Sony and Philips. It also has to deal with the $521 million and rising Eolas decision, which it has promised to appeal. It also appears there may be a number of other significant suits that haven't surfaced yet or haven't been publicized.

Sun is supposed to license communications protocols from Microsoft under the program established under the terms of Microsoft's settlement agreement with the United States government. Those are the protocols Sun bitched to the Justice Department cost too much.

Microsoft is going to continue peddling the Microsoft Java Virtual Machine that it was going to excised from its software.

Microsoft has already certified Windows on Sun's Xeon servers. Its AMD boxes come next.

Microsoft and Sun are supposed to get access to "aspects of each other's server-based technology" and propose to use it to develop new server software product that work better together. The cooperation is supposed to center on Windows Server and Windows Client at first, but will eventually include e-mail and database software as well as other unidentified stuff.

The Liberty Alliance-Passport authentication divide looks like it's also being sewed up. Sun and Microsoft engineers are supposed to cooperate to allow identity information to be shared between Microsoft's Active Directory and Sun's Java System Identity Server.