Analysis By Tim Weber Business editor, BBC News website

In the first of two reports, we examine the challenges facing Microsoft.

Look closely: the bedroom mirror hides a computer monitor

It looks like a Star Trek gadget: nudge the stubby black stick (no wires) and a virtual keyboard glitters in red on the kitchen worktop.

After a few taps, the shopping list is sent to an online grocer.

Next you could video-conference with a friend to swap recipes, or watch a cooking show stored on the hard drive of the media hub in the living room.

Upstairs, the mirror on the bedroom wall becomes a monitor, allowing you to watch a film, browse the web - or turn up the heating and open the blinds.

Welcome to Microsoft's wireless "M.home", on a leafy street in London's Ladbroke Grove.

Microsoft is in its most vulnerable moment in history, just like IBM in the 1990s George Colony, Forrester

"This is not the home of the future," says Cynthia Crossley, who is in charge of Microsoft's Windows operating system in the UK. "All the technology can be bought off-the-shelf and fits subtly into your home."

Driven by Microsoft's Media Center software, the showcase home lends credibility to the promise of Microsoft boss Bill Gates that in a few years' time his company will deliver a "user-centric" digital world.

Reality check

Alas, the M.home is a far cry from real life: where few computers link up to hi-fi and television, where complex software, hardware and competing media formats drive users to despair, and where setting up wireless home networks is a black art.

MICROSOFT HQ: Redmond, Washington Sales: $36bn (2004) Profits: $8.2bn (2004) Staff: 57,000 Founded: 1975 Chairman: Bill Gates Chief executive: Steven Ballmer

Security is another issue. Millions of computers running Microsoft's Windows operating system are under constant virus attack and riddled with spyware.

Microsoft, meanwhile, finds itself hassled by ever more competitors.

"Microsoft is in its most vulnerable moment in history, just like IBM in the 1990s," says George Colony, the chief executive of technology research firm Forrester.

Vulnerable? The company whose software powers more than 90% of all the world's personal computers?

Linux and friends

Microsoft may have a monopoly right now, says Mr Colony, but "protection of a monopoly is tricky".

And there are plenty of challengers ready to put Microsoft's durability to the test.

Foremost among them is the Linux operating system.

Linus Torvalds wrote the original code for Linux

Rivalling Windows, this "open source" software project is developed by an online community of volunteers, but backed by big and small corporate players (like IBM and Red Hat) who provide support and tailor the software for individual business needs.

Linux, its champions say, is more stable and secure than anything Microsoft has ever produced.

It is cheap - even free if you are computer-savvy enough to install and maintain it - and much more customisable, because the code that makes it tick is neither a secret nor copyrighted by a single firm.

These days Linux is not just the software of choice for geeks; recently even the stolid bureaucrats of Bavaria's capital Munich decided to switch all their computers to Linux.

China, South Korea and Japan, meanwhile, have joined forces to develop an Asian flavour of Linux, to ensure they are not in thrall to Microsoft.

Other parts of the empire are under attack too, such as the hugely profitable "Office" suite.

Don't want to pay for a word processor, spreadsheet, database and presentation tool? Download OpenOffice. It won't look as nice as Office 2003, but it's free and fully featured.

Editing pictures? You don't have to pay for Microsoft's "image suite". The open source "Gimp" is powerful, while Google's free Picasa will meet the everyday needs of most consumers.

The browser war

Bill Gates promises great things for "the third decade of Windows"

Microsoft's biggest worry, though, should be the huge success of Mozilla Firefox, the open source web browser.

Faster and more secure than Internet Explorer, it is the first browser to seriously challenge Microsoft's dominance.

In just nine months Firefox has chalked up 50 million downloads, although some are admittedly upgrades.

Bill Gates is one of the people with Firefox on his computer, so I asked him for his opinion.

"I played around with it a bit, but it's just another browser, and IE [Microsoft's Internet Explorer] is better," Mr Gates told me, and challenged my assertion that Firefox's 'market share' is growing rapidly.

"So much software gets downloaded all the time, but do people actually use it?" he argued.

Apple takes a bite

In this fast-moving technology market, Microsoft's biggest problem may be its very size.

Will the iPod generation go on to buy Apple computers?

"Microsoft is not an innovator or transformer right now," says Forrester's George Colony. Many rivals are more focused and nimble.

Take a company like Skype with its software for free internet telephony, successfully invading the turf of Microsoft's MSN Messenger.

Or long-term rival Apple, whose iPod media player and iTunes music store have thrown Microsoft's music ambitions into disarray.

And even giants like mobile phone maker Nokia give Microsoft a run for its money, pushing their own mobile software into the pockets of millions of consumers.

Microsoft squeezed

"Companies are not afraid of competing with Microsoft anymore," says Marc Benioff, the boss of salesforce.com, which offers a service over the internet which competes with Microsoft in the lucrative market for "customer relationship management" software.

"Microsoft is a great business... but people don't want big software applications any more," he claims.

It also works for consumers. Why use Microsoft if you have a broadband connection and combine Firefox with powerful web services like Google's Gmail?

Here is Microsoft's problem: while rivals try to pick off its software offering one by one, new ways of writing software - for example open source - speed up the pace of innovation and threaten Microsoft's business model.

Bill Gates wants to push Microsoft into the mobile space

The fate of "Longhorn" is a case in point. The much-heralded successor to Windows XP is badly delayed and key components won't be ready for launch.

"We are working hard to get it on the market in 2006 and scale our ambitions to fit with that," Mr Gates admits.

Thus users will have to wait until 2007 for Longhorn's revolutionary filing system, designed to help find information buried in ever larger hard drives.

Once ready it will be deployed as part of a Longhorn service pack, says Alistair Baker, boss of Microsoft UK.

But Apple's brand-new "OS X Tiger" operating system offers this kind of functionality today.

Add Microsoft's ongoing trouble with regulators - the company is already talking to US authorities about Longhorn - and the picture of a rich but troubled company is complete.

Forrester boss George Colony predicts that there will be "a crisis at Microsoft, where they decide their model is broken".

But remember Netscape, which dominated the internet - only for Microsoft to catch up.

Bill Gates has a clear strategy. His company has very deep pockets.

And his fightback starts now.