Microsoft was willing to pay $47.5 billion, or $33 per share, up from the bid's current value of $29.40 per share, according to a letter from Microsoft Chief Executive Steve Ballmer to Yahoo Chief Executive Jerry Yang.
But Yahoo demanded at least $53 billion, or $37 per share, according to Ballmer. That would have been nearly double Yahoo's stock price of $19.18 at the time Microsoft first made its bid a little over three months ago.
"Clearly a deal is not to be," Ballmer wrote.
A spokeswoman for Sunnyvale-based Yahoo didn't immediately return a call seeking comment.
The decision to walk away came as a surprise, given that many analysts believed Microsoft wanted to close the deal badly enough to either sweeten the offer or pursue a hostile takeover - a risky maneuver that would have required an attempt to replace the Yahoo board that spurned rejected the bid.
But Ballmer said he concluded that pursuing a so-called proxy battle was "not sensible."
"Our discussions with you have led us to conclude that, in the interim, you would take steps that would make Yahoo undesirable as an acquisition," Ballmer wrote to Yang.
But Yahoo hasn't necessarily faded from Microsoft's crosshairs.
The software maker conceivably could renew its bid later this year if Yahoo can't bounce back from more than two years of financial lethargy.
Should Yahoo's turnaround efforts flop, many analysts believe the company's stock would sink into the mid-teens and open the door for another takeover offer that would be more difficult to rebuff.
For now, at least, Microsoft appears to believe it has enough internal weapons to chip away at Google's dominance of the booming Internet ad market.
"We have a talented team in place and a compelling plan to grow our business through innovative new services and strategic transactions with other business partners," Ballmer said. "While Yahoo would have accelerated our strategy, I am confident that we can continue to move forward toward our goals."