An anticipated August 1 bloodbath might be averted. In an unexpected and highly controversial settlement, the board of directors at Yahoo! and agitator investor Carl Icahn have reached an agreement which makes Icahn a board member. In return, Icahn has agreed to call off his hostile proxy fight for control of the Yahoo! board.

Icahn owns or controls approximately 5% of Yahoo! common stock, with 68,789,320 shares. He has agreed to pull a slate of alternative board members he assembled earlier this year in his bid to take over the troubled corporation. Icahn has further agreed to use his block of votes to support the nominees put forward by the current board of directors.

After the August 1 election, the Yahoo! board will expand from its current nine members to eleven with Icahn guaranteed a seat via appointment. Two other appointments from the list of eight alternative nominees Icahn had earlier compiled will be added after the new board is elected. A ninth name, Johathan Miller (the former chair and CEO of AOL), will be added to that list.

Jerry Yang remains CEO, at least for now. The constitution of the remaining seats on the Yahoo! board is still up for vote with eight current board members, including Yang facing re-election. Roy Bostock, Ronald Burkle, Eric Hippeau, Vyomesh Joshi, Arthur Kern, Mary Agness Wilderotter and Gary Wilson are the other seven candidates. Robert Kotick has withdrawn his name from the Yahoo! slate.

News of the settlement, which broke early this morning, puts the sale of Yahoo!’s search and network assets into question. Icahn got involved in Yahoo!’s business shortly after Microsoft offered to purchase the company for approximately $33/share on February 1. He had threatened a hostile proxy fight in order to take control of Yahoo!’s board in order to push the sale through. Over the past six months however, the story of the sale has taken some bizarre and often unexplainable twists and turns as Microsoft and Yahoo! have exchanged barbs over wildly different versions of why negotiations have thus far failed. For the last few months, Icahn has been busy in the background trying to broker a deal with Microsoft CEO Steve Ballmer in the expectation he would gain control of Yahoo!’s board.

As the story was working out an Icahn controlled Yahoo! was quickly becoming plausible. If Icahn’s take-over had materialized, he said he would move quickly to sell the search share of Yahoo!’s business to Microsoft. That would leave a wounded portal-network with no long-term business plan under his control. The truth is, nobody wanted Icahn, who personally has limited Internet and computer experience, to actually run Yahoo!.

Reflecting a lack of investor confidence in Icahn, another large holder of Yahoo! shares, Bill Miller from investment house Legg Mason, announced last week that he would use his 4.4% stake to vote for candidates favoured by Yahoo!’s current board. This might have been the announcement that broke Icahn’s resolve, convincing him to take the agreement.

Does this agreement shut Microsoft out of the picture? Certainly not though it does make the path to acquisition far less simple for Ballmer and Co. Investors recognized that this morning as prices of Yahoo! shares fell nearly 3% to a low of $21.65. Yahoo!’s current market cap is $30.07 billion.

One last interesting bit in this evolution of the story is the virtually guaranteed appointment of former AOL CEO Jonathan Miller. Rumours have it Miller is being considered as Yang’s replacement in the position as CEO of Yahoo!. His appointment threatens a chain of command that extends back to the beginning of the Semel years, challenging Susan Decker’s chances of becoming CEO.

Though a bloodbath has been averted at Yahoo!’s August 1 annual general meeting, the drama in this story continues.