To win the case, Microsoft must now prove that the patent is invalid.
The dispute dates back to 1999, when Microsoft was sued by the University of California and Eolas Technologies over allegations that its Internet Explorer program infringed a patent for a method that allows web browsers to access interactive application programs.
In August 2003 a jury agreed with the claim and awarded damages of $520.6 million plus interest to Eolas. This verdict was upheld in January 2004 and a Chicago District Court imposed an injunction on the software firm, banning it from distributing the infringing software.
The ban was stayed pending an appeal - the result of which was announced yesterday.
The appeal, filed in June last year, related to limitations placed on the extent of prior art evidence that the District Court allowed Microsoft to put forward to support its claim that the technology behind the Eolas patent was already in the public domain and that the patent was therefore invalid.
Microsoft argued that an earlier browser with the same abilities, known as Viola, had been developed by software designer Pei-Yuan Wei before the Eolas patent was filed. Microsoft said the District Court had not permitted it to put forward evidence about Viola because it found that Wei had "abandoned, suppressed or concealed" the browser after its invention. It was therefore not prior art, said the District Court.
Microsoft argued that Wei had put the browser in the public domain by demonstrating it to engineers at Sun Microsystems in May 1993, and then posting it on a web site. Evidence of Viola should have been put to the jury, it said.
Michael Doyle, one of the inventors of the Eolas patent, also held back evidence of the Viola browser from the US Patent and Trademark Office (USPTO), said Microsoft.
The Appeals Court agreed, at least in part, finding that while there had been infringement of Eolas' patent, the trial judge had erred in not allowing the software giant to put forward either the Viola evidence or evidence of inequitable conduct on the part of Doyle. The case has therefore been sent back to the District Court for a retrial on these issues.
Effectively this means that while Microsoft has been found to infringe on the Eolas patent, it has a second chance to show that the patent itself should not have been granted.
Microsoft had also petitioned the court to include only the US sales of Windows in the calculations relating to the fine imposed on the company. However the Appeals Court upheld the earlier ruling on this point, finding that foreign sales of the operating system should also be included if the patent was found to be valid.
"Today's Appeals Court decision overturning and remanding the District Court verdict in the Eolas patent case is a clear victory not only for Microsoft, but for internet users as well," said Microsoft in a statement. "We have maintained throughout this process that the Eolas patent is not valid, and today's ruling is a clear affirmation of our position."
Trey Davis, spokesman for the University of California gave CNET News.com a different picture. "We cleared most of the serious issues, so I would consider this a victory for the university," he said. "On the issues that would have mattered most to Microsoft, they lost."
Software developers around the world are heaving a small sigh of relief because, if upheld, the Eolas patent seems likely to be of widespread applicability.
Such is the concern over the case that in October 2003, Tim Berners-Lee, director of the W3C, the international standards-setting body for the internet and the man credited with inventing the World Wide Web, wrote to the USPTO. He asked that the patent - known as patent '906 - be declared invalid due to prior art.
The USPTO is now in the middle of re-examining the patent and has issued two rulings, both of which were in favour of Microsoft. However, a definitive decision from the USPTO could take years, according to commentators.