The Justice Department will demand that Microsoft Corp. break itself up into three separate companies as a condition of an out-of-court settlement of the government's antitrust lawsuit, according to sources close to the case.

The department's demand will be presented at talks now underway in Chicago, where Justice, 19 states and the company are attempting to negotiate an end to their long-running legal fight before the trial resumes next month. The proposal, which amounts to a high-stakes opening offer, makes it clear that Justice has concluded that anything less than a divided Microsoft will not restore competition in the multibillion-dollar software market.

Microsoft is certain to object, which could either produce a middle-ground agreement or scuttle the talks. In that event, Justice could ask the federal judge handling the case to order the breakup, all but guaranteeing a years-long slog through appeals courts.

A breakup would have a direct and wide-ranging impact on the hundreds of millions of people around the world who use personal computers. Microsoft--which sprinted to the highest valuation in stock-market history--would cease to exist as a single concentration of vast wealth. The company's domination of the computer-related technology industry could also come to an end. And no longer would only one firm sell Windows, the operating system that runs 90 percent of the world's personal computers.

Justice's intention to seek a breakup was first reported in yesterday's editions of USA Today. That report, which said the department wanted the company split into two parts--one company selling only Windows and one company selling other software applications--sent Microsoft's shares tumbling more than 3 percent yesterday.

Details of Justice's proposal are sketchy, in part because it is a work in progress, according to a source familiar with the talks. Justice and the 19 states that joined the lawsuit are negotiating among themselves about which remedy to demand at the next negotiating session. The states have already made it clear that they would favor a Microsoft breakup.

Justice officials declined to comment, noting that the department has refused to discuss the settlement talks. Justice spokeswoman Gina Talamona would say only that the USA Today story "does not adequately reflect our views."

Microsoft spokesman Mark Murray yesterday said that any recommendation to split up the company is "an extreme, radical proposal that's not justified by anything in this case and doesn't reflect the reality of competition in our industry."

"It's a little ironic that anyone would be talking about breaking up Microsoft a day after AOL and Time Warner announced the largest merger in history, one aimed at competing directly with Microsoft," he added.

There are several ways Microsoft could be divided, and it is not clear which approach the government favors. One approach would be to split Microsoft horizontally into a company that sells the Windows operating system, one that sells applications such as the Office software suite, and another that provides Internet-related software and services. Another would be to split the firm vertically into two or three nearly identical units, already dubbed "Baby Bills" in reference to the company's billionaire chairman, Bill Gates.

A third approach would combine the previous two, splitting the applications side of Microsoft from the operating-system side and then dividing the operating-system unit into two competing companies. That concept, which several antitrust experts believe Justice favors, would reduce the chance that one company with an operating-system monopoly would use that power to dominate other markets, an ability that Justice alleges Microsoft has illegally exploited.

If there is only one operating-system company, "you have to say they can't enter into the applications business again, and you have to police those restrictions, which would be a mess," said William Kovacic, a law professor at George Washington University. "What Justice wants is competing operating-systems companies, and that's the logic of a three-way split."

For consumers, a Microsoft breakup could mean lower prices for operating-system software and an increase in the number, variety and quality of applications for sale, according to some industry analysts. With several firms selling Windows, some economists predict, prices would fall and consumers would get more product options.

But skeptics of such an approach worry that one of the firms might add features that would make its version of Windows incompatible with others, causing headaches for consumers who have come to depend on the near-ubiquitous Windows "standard."

Another challenge for the government in a breakup would be the division of employees. Microsoft's most valuable assets aren't made up of factories, oil refineries or railroad lines that can be split in two or three ways. Most of Microsoft's property is intellectual, and as such, its chief resource is people. Which company would get Bill Gates? How would the programmers be split up? And what would prevent employees assigned to the non-Gates firms from quitting and joining Gates's company?

Proposing a breakup also could subject the Justice Department to a new round of political criticism from congressional Republicans, many of whom have lined up behind Microsoft and would be quick to attack the Clinton administration as a destroyer of one of America's most successful companies.

U.S. District Judge Thomas Penfield Jackson ruled in November that Microsoft has used its monopoly power in the market for PC operating systems to bully rivals, squelch competition and harm consumers. Jackson's ruling, however, only addressed factual issues in the case. If no settlement is reached, Jackson probably will issue a final ruling that will address whether Microsoft's conduct violated antitrust laws.

In early December, two weeks after issuing his "findings of fact," Jackson tapped Richard A. Posner, the chief judge of the 7th U.S. Circuit Court of Appeals, to serve as a mediator in the case.

The option to break up Microsoft has been one of several remedies under consideration by Justice and the states. Other sanctions under discussion have included court-ordered limits on the company's behavior and a requirement that Microsoft share the secret software code that makes up Windows.