Unchallenged leader in cyberspace access at home -- 16 million U.S. customers and counting -- America Online Inc. has been humbled in Britain this year. Today it will strike back with its competitors' weapon: free Internet service.

AOL plans to announce no-charge service that will only be available in Britain, but the Dulles-based company may extend it to the continent, where it's starting to feel heat from other free services and the former national telephone monopolies in France and Germany that are offering the Internet at rock-bottom prices.

AOL has no plans to offer free service in the United States -- the economics of signing on America are quite different than in Europe, where people pay a telephone company by the minute for local calls and Internet services collect part of customers' phone payments.

But the free service is crucial to AOL's hopes to restore its status as the No. 1 online service in Britain, where it recently has been overtaken by Freeserve, one of a new breed of companies that charge people nothing to let them connect to the World Wide Web for as long as they want.

Keeping up with growth in Europe is important for AOL's future. While the company still has plenty of room to grow in the United States, where an estimated 37 percent of households are online, the potential is even higher in under-wired Europe. Only 13 percent of households are online in Germany, only 4 percent in Italy, the research firm Jupiter Communications said.

In the United States, many stock analysts believe that concern over the new form of competition in such important overseas markets has helped push down AOL's stock price from a high of about $167 in April. It closed Friday at about $119.89 a share, down about $1.11, on the New York Stock Echange.

AOL executives say they are not too late in offering the free links in Britain, which they hope will attract new Internet customers without draining away those who now pay monthly for AOL. They will have to work hard, however, to get back people like Fergel Grist.

Grist, a London computer consultant, used to subscribe to AOL's British service, which is operated as a joint venture with the German media company Bertelsmann AG. Last January he switched to Freeserve, the No. 1 provider, and has never looked back.

"I think it's great," he said, as red double-decker buses rolled along the shopping street behind him. Grist used to run up his monthly AOL bill to about $47. "Now it's zero," he said. "And I prefer Freeserve. I think AOL is in terrible trouble."

Analysts generally agree that AOL's British service does have problems. "AOL got caught with their pants down and have been slow to react," said Michael Chamberlain, head of media in Europe for consultants Arthur D. Little & Co.

AOL will continue its regular subscription service in Britain. Consumers who sign up for the new service will be unable to see AOL's proprietary material. But using the Netscape "browser," they will be able to go anywhere on the Web and send and receive e-mail.

"What is driving the company is a multi-brand strategy," said Andreas Schmidt, chief executive of AOL Europe. "It's going to be a success story."

AOL remains the largest pan-European Internet provider. But analysts say it should have realized sooner that customers who pay both the Internet service and the phone company were ripe for serious price competition -- and free competition.

Metered pricing also means that customers are less likely to stay online for hours at a time and engage in lucrative -- for AOL -- side offerings, such as online shopping and advertising. "If people are metered, they're not going to stop to window-shop," said Abhishek Gami, an analyst with investment banking firm William Blair & Co. in Chicago.

Yet it is metered calling that provides the financial underpinnings for the free services. By making deals with telephone companies, the free services live off a portion of the calling revenue that their sites generate. Because U.S. phone companies don't bill local calls by the minute, most analysts say it would be much more difficult for a free Internet access system to prosper in the United States.

Companies such as Freeserve hope to profit in a big way from advertising and shopping revenue in the future. But for now they are relying on their portion of the calling revenue -- in Freeserve's case, more than 1 million British users. That service, started by the British electronics chain store Dixons, plans a public stock offering next week valued at about $2.2 billion.

On the European continent, free-service providers are springing up more slowly. FNAC, a French book-and-electronics chain, started such a service in May, and other competitors are widely predicted. Adding to AOL's competition in France and Germany, the former national telephone monopolies there are pricing their own Internet services -- the No. 1 providers in each country -- at next to nothing because they too can profit from higher calling volume.

The challenge for AOL in Britain will be to market its free service as better than the other free providers -- for example, it will have such AOL features as instant messaging -- but not as a scaled-down version of AOL or its Compuserve affiliate. "If you say to people, `I'm going to give you something that's second-best,' I'm not going to beat a path to your door," Chamberlain said.

Schmidt and John L. Davies, president of AOL International in Dulles, say there is room for the two forms of AOL, as they appeal to different groups of people. Company research found that free-service users were younger, more male, less well-paid and more likely to be single than users of subscription services. "If there is a segment there, we will find a way to serve it," Davies said.

AOL's recent troubles have given it a far different image in Britain than the glowing reputation it enjoys in the United States. As the Financial Times recently wrote, "America Online has learnt two lessons about Europe. First, it is not America. Second, it is not yet fully online."

Still, the image of a premium service beset by free competition may make it more difficult to AOL to sign up as many new customers as it likes.

"AOL costs an arm and a leg, don't it?" said 66-year-old taxi driver Derek Newman, who happily surfs on Virgin Net, the free service offered by Richard Branson's transportation and entertainment empire. Even if AOL offered a free service, he wouldn't consider switching. "If it's not broke, why mend it?"

AOL doesn't actually cost an arm and a leg any more. In an initial response to the free competition, it drastically cut its rates earlier this year in Britain and Germany. Unlimited use in Britain now costs about $16 a month.

Still, some analysts here fault AOL for focusing too much on subscription income. In Europe, 95 percent of its revenue still comes from subscriptions, compared with about 80 percent in the United States, where advertising and electronic commerce are more developed.

"It's important to stress that in the early stages of a market it's more important to gain market share than to be profitable," Jupiter Communication's Noah Yasskin said. "That's been one of their problems, their approach to the market. They've been a bit strait-jacketed."

In Britain, the company has tested another possible payment system twist: providing a toll-free number so that paying subscribers can get unlimited usage for a fixed monthly fee, without running up their phone bills. That's just like the service in the United States.

Such an option would be costly to AOL, which would pay for the lines, but with people not worrying about the ticking clock, they might generate more revenue for the company through ads and electronic commerce. Schmidt said the results of the tests are "very encouraging."

Still, it is impossible to exaggerate the presence of free services in Britain. Each of the four or five glossy Internet magazines on sale here is stuffed with three or four CD-ROMS from free providers. And the number is growing all the time: Even the champion soccer team Manchester United is launching one, in connection with MCI WorldCom Inc.

Across the Atlantic

The percent of U.S. households that are online outpaces that of European countries.

Percent of households online, year-end 1998

United States 37%

Sweden 23

Finland 20

Norway 20

Denmark 20

Netherlands 15

Germany 13

Switzerland 12

Britain 11

Austria 7

Belgium 6

France 6

Ireland 5

Spain 4

Italy 5

Portugal 1

Number of subscribers

Germany

Deutsche Telekom (T-online) 3.3 million

AOL* 1.1 million

France

France Telecom(Wanadoo) 780,000

AOL* 400,000

Britain

Dixons(Freeserve) 1.1 million

AOL* 1 million

*includes CompuServe subscribers

SOURCE: Washington Post survey