Speaking on an American television show yesterday, Bill Gates admitted surprise at the blockbusting merger between the internet service provider America Online and Time Warner earlier this week.

"Well, I didn't predict it," he said. "I can understand why they did it. It's an absolutely gigantic company, it's a fierce competitor of Microsoft in many areas."

Mr Gates was hardly alone in being wrong-footed by the deal, but the man for so long regarded as a visionary in the world of hi-tech may have just found himself facing the malaise of any middle-aged man - losing touch.

The combination of AOL, with screens in 20m homes in the US, and Time Warner's almost limitless archives of film, music, television and print should raise concerns in Seattle.

Microsoft has found itself under increasing pressure from younger, more nimble companies, which often seem more able to understand where the market is headed.

New stars of the software market include VA Linux, a collaborative, extendable "open source" system that can be downloaded free from the internet, which was created by Linus Torvalds nine years ago when he was 21. Linux saw its shares soar more than 700% on its first day's trading last year, from $30 to $239 (about £147).

Red Hat, another rival, trebled its value on its first day's trading and is now worth more than $18bn.

As the market has moved away from the traditional PC it has played into the hands of Microsoft's arch-rival Scott McNealy, chairman of Sun Microsystems.

Microsoft also faces renewed competition from Apple, which began to regain ground after its founder, Steve Jobs, returned to the company two years ago. Mr Jobs made Microsoft look out of touch when it introduced style into computers with the polished curves of its iMac.

But it is in the internet that Microsoft has been slowest to adapt. It took until last year for the company to drop its mission statement of putting a PC on every desk, but the software market has been moving away for some time.

Much of the focus in the near future will be on mobile phones, which are forecast to be the most pervasive method of access to the internet. Again, Microsoft has been slow to react and in this instance has come under pressure from a British company, Psion. The company owns a third of Symbian, which developed the epoc operating system into a world leader.

Mr Gates identified Psion as its most potent threat in a leaked internal memo and in December announced a joint initiative with handset manufacturer Ericsson, causing shares in Psion to fall 40%.

Microsoft has also been investing in cable television companies, with an eye on the digital revolution that will bring internet access into the living room. Its 5% stake in NTL appeared to pay off last week when Microsoft software was chosen for the next generation of that company's set-top boxes.

Microsoft's advantage is sheer scale and its firepower means it can never be counted out of the action.