Microsoft issued a statement that they withdraw their offer to buy Yahoo!.

Microsoft published the letter Steve Ballmer sent to Jerry Yang. Microsoft was willing to increase the offer to $33 per share.
Because Yahoo is possibly planning to run Google Ads Microsoft is also not pursuing a hostile takeover.
Looks the 3month long story comes to an end and there will be no Yahoo acquisition in any form by Microsoft.

It will be interesting to see what now happens to Yahoo. Will they stay independent? Will Google try to bind Yahoo closer to them? Will they go out of business? Will some other media power-house swoop in and try to acquire Yahoo? Everything is possible.

Read the full statement and letter to Yahoo! on the Microsoft site. Update: Yahoo response to Microsoft's Bid Withdrawal.