Last week, Google announced it might exit from China market because of a recent hacker incident and Chinese government’s interference over Internet. This came as a surprise to most industry watchers, especially when Google China’s business is in fact getting better and better.

Recently, it was able to gain market share from the local leader, Baidu. Google had a 35.6% share of market in the fourth quarter last year, compared to 31.3% in the third quarter, while Baidu’s share fell to 58.4% from 63.9%, according to Analysys International, a Beijing based market research firm. And this is a dramatic difference from what Google had 3-4 years ago, when it just entered China market – Google’s market share was as low as 16% in the second quarter of 2006, a year after it set up its China office. At that time, Baidu had 50%, according to Analysys International.

And Google has momentum to do even better. Google developed mobile search much earlier than Baidu. According to former Google China president, Lee Kaifu, Google started developing mobile search in 2007, and it was, and still remains, one of its key focuses. It has China Mobile, China’s largest mobile operator, as its mobile search partner since 2007. Baidu only started to develop mobile search last year, and last May, partnered with the smallest of the three operators, China Telecom. As 3G rolls out in China, more and more people will search the internet with their phones. Google’s advantages (over Baidu) should be even more apparent.

If Google can gain a further 5% from Baidu, that is 40% against Baidu’s 50-55%, Google will no longer be just a small rival. It will be a serious competitor to Baidu, and a powerful player in China internet space. So, why it chose to leave China market now?

With 384 million users, China has become the world’s largest internet market and it is still growing very fast – internet users increased 28.9% from a year earlier. (Note: the figure is from CNNIC, a Chinese government back research institute.) Moreover, it has a lot of room to grow, as only 29 percent of China’s population is online. Why walk away from such potential, when your China operation is in fact doing well?

It is really bizarre, from any business points of view. But, an industrial insider suggested, there might be a chess game being played right now.

The Google announcement (http://googleblog.blogspot.com/2010/01/new-approach-to-china.html) said it detected “a highly sophisticated and targeted attack originating from China” and “a primary goal of the attackers was accessing the Gmail accounts of Chinese human rights activists”.

Then after a long discussion of significance of the event, it said, “We have decided we are no longer willing to continue censoring our results on Google.cn, and so over the next few weeks we will be discussing with the Chinese government the basis on which we could operate an unfiltered search engine within the law, if at all.”

This, at the first glance, might look like a suicidal note – Chinese government is not used to back down on foreign company threats. Dick Wei, China Internet analyst of JP Morgan said Google would leave by February. And most analysts agreed with him – Google would cease its operation in China.

But, let’s look closer to the announcement:

Human right and unfiltered search result are related, because freedom of speech is part of human right. However, they are separated issues. Why Google mentioned the hacker’s attack to human right activists’ account, as the pretext of its intention to run an unfiltered search engine in China?

The following is a theory: it might be the case that, Google has hard evident tracing the hackers to Chinese government. Google, being the world’s largest search engine, should have the technology and capability to trace the hackers back to their origins.

Google might have given the evident to the U.S. government. That is why the U.S. government willing to back it up as it made the announcement. “We have been briefed by Google on these allegations, which raise very serious concerns and questions. We look to the Chinese government for an explanation. The ability to operate with confidence in cyberspace is critical in a modern society and economy,” said U.S. Secretary of State Hillary Clinton right after the announcement. She is expected to deliver a major policy address on Internet freedom this Thursday in Washington, D.C.

With hard evident on hacker attack, Google hoped to use this as leverage to gain better cooperation from Chinese government – and what it wanted the most was no censorship on search results.

As Chinese online users approaching 30% of its total population, government censorship on internet is becoming harsher and harsher. Past experience showed, even with self-imposed censorship, Google.cn still upset the Chinese government from time to time. Stated owned China Central Television, accused Google of providing links to obscene content in its news program last December.

(This was in fact not limited to Google, some Chinese search engines, Baidu and Sohu’s Sogou, also suffered.)

In the end of the statement, Google said it is going to talk to Chinese government in the next few weeks. If the theory is right, what it really means is: leveraging on hard evident on hacker attacks, Google wants to negotiate with the government for a better working environment in China.

So far, Chinese government’s reaction has been mild – Chinese foreign ministry spokeswoman Jiang Yu said that company has to cooperate “according to law”, but “China’s Internet is open”.

“The Chinese government works hard to encourage the healthy development and expansion of the Internet, and works to create a favorable environment for that,” Jiang added.

So, it seems the Chinese government is willing to negotiate. In the next few weeks, it will be interesting to see what come out from this show down. Google’s wish is to “run a unfiltered search engine”. The government’s bottom line is “according to Chinese law”. Would there be some kind arrangements, which make both parties look like winners? This might be tricky, but not impossible, as how to interpret what is “according to Chinese law” can be quite flexible, as people doing business in China know.

One way of doing it is to let Chinese government to do the censorship itself, said the industry insider. Google will run the unfiltered search engine, and Chinese government can block any results they do not like, just like the case before Google formally entered China. Only that the blocking might not be as heavy hand as people expected. And Chinese internet users can still use Google for most of their daily searches.

If Google can do its negotiation right, and get Chinese government to compromise, it might have even more room to maneuver in the future. If that is the case, Baidu, whose stock price raised 10% right after Google made that announcement, might be the one to be threatened.

Google is already the preferred search engine of many better-educated and wealthier Chinese internet users, especially in the major cities. The publicity Google gained over the incident inside China is like free advertisements for the global search giant. (Just look at the pictures of people placing flowers in front of Google’s Beijing office. And contrary to some reports, local press carried those, too. Here is a link to Global Times, a Beijing based newspaper, http://business.globaltimes.cn/world/2010-01/498731.html). More Chinese internet users will try it. They might do it purely out of curiosity, might just to see if there is any difference from Baidu. And some will stay, because Google is actually better in some aspects, for examples, its translation and maps applications are more sophisticated than that of Baidu.

Only if the negotiation fails, Google will shut down Google.cn and leave China. But that does not means it is a total loss. Google’s China business can be divided into three parts: 1) selling search ads to target domestic market, i.e. Google.cn, 2) selling search ads to target international market, i.e. Google.com, 3) Adsense Network, through which Google directs ads of its advertisers to websites that joined its affiliated program.

Only the first business is directly affected if Google.cn is shut down. Chinese advertisers who want to target international market can still use Google.com. And Google’s Adsense network can still operate, for advertisers to reach Chinese consumers through hundreds of thousands Chinese websites who have joined Google’s affiliated program. Google run the largest affiliated network in China, with over 200,000 websites, including leading Chinese portal, Sina.

No matter what happens in China, a prize Google has already won in this chess game is the heart of it global audients, especial those in its home country, the U.S. The positive publicity generated from the incident can help to secure Google’s position as the number one search engine in the world.

History shows Google has done what seem crazy on the surface, but smart in the end before, for example, the spectrum auction in the US, the Android free mobile phone software, the original idea of a stand alone search website with free results paid for with text advertising, etc. This show down with China government might be another huge bet the search engine giant made, which might pay off in the end.