Carl Icahn isn’t the only big-name investor taking a big stake in Yahoo (YHOO). Paulson & Co., the hedge fund run that made a killing last year betting against subprime mortgage securities, bought 50 million Yahoo shares in the first quarter, which ended March 31, a Securities and Exchange Commission filing shows. John Paulson, the manager who made $3.7 billion last year on his timely subprime wager, made the big Yahoo purchase during a quarter in which Yahoo fielded an unsolicited bid from Microsoft (MSFT). Microsoft has since walked away from that deal, but Icahn is leading a proxy fight against Yahoo’s board, perhaps in hopes of turning up the heat for renewed deal talks. If he succeeds, Paulson stands to make a few more bucks.

Update: Paulson will support Icahn’s effort to unseat the Yahoo board, Bloomberg reports. “We intend to support the Icahn slate but sincerely hope that Yahoo will negotiate an agreement with Microsoft, thereby making a proxy fight unnecessary,” Paulson said in a statement emailed to Bloomberg. “We were disappointed that Yahoo failed to reach an agreement with Microsoft.”

One name that stands out on Carl Icahn’s proposed board slate for Yahoo (YHOO) is Mark Cuban. Cuban, the billionaire owner of the Dallas Mavericks and the HDNet high-definition TV broadcaster, made the bulk of his fortune running Internet video firm Broadcast.com and then selling it to none other than Yahoo. Broadcast.com went public in 1998 and saw its shares triple on their first day, before Yahoo bought the company in 1999 for $5.7 billion.

Others on Icahn’s board slate - besides himself and standbys such as his right-hand man Keith Meister and former Viacom (VIA) chief Frank Biondi - include New Line Cinema chief Robert Shaye, investors John Chapple, Brian Posner and Edward Meyer, Michael Dell’s brother Adam and Harvard Law School professor Lucian Bebchuck.

But Cuban’s name stands out, because of his history with Yahoo and his success in building businesses on the Internet. On Thursday, for instance, he has a post up on his Blogmaverick.com site musing on how to take down Google (GOOG). While that’s a question Yahoo execs are presumably tackling, the last few months have clearly left some shareholders with the sense that management is more focused on saving its own skin - which is why Icahn’s spoiling for a fight.

Carl Icahn is out with his first shot across Yahoo’s (YHOO) bow. Icahn, the activist investor who has been building a stake in the Internet company in anticipation of a proxy fight, says he wants to replace the board so he can put together a deal with Microsoft (MSFT). Icahn says he believes the board has “acted irrationally and lost the faith of shareholders and Microsoft” by turning down a sweetened takeover bid at $33 a share. In typical fashion, Icahn goes on to call Yahoo’s actions “irresponsible” and “unconscionable,” and pronounces himself “perplexed.”

Icahn isn’t allowing his perplexity to stand in the way of action, however. He says he owns 59 million shares, has assembled a 10-member alternative board slate and has asked the Federal Trade Commission for permission to buy as much as $2.5 billion worth of stock. Icahn’s current stake is worth $1.6 billion at Thursday’s price of $27.45 a Yahoo share.

“During the past week, a number of shareholders have asked me to lead a proxy fight to attempt to remove the current board and to establish a new board which would attempt to negotiate a successful merger with Microsoft, something that in my opinion the current board has completely botched,” he writes in a letter to shareholders. “I believe that a combination between Microsoft and Yahoo is by far the most sensible path for both companies.”

Carl Icahn is going after Yahoo (YHOO). The billionaire investor is launching a proxy fight seeking to replace the Internet company’s entire 10-member board, The Wall Street Journal reports, citing a person close to the matter. The decision comes ahead of Thursday’s deadline for nominating alternative board slates, as Fortune’s Yi-Wyn Yen notes. The Journal reports that Icahn approached Microsoft (MSFT), which earlier this month withdrew an unsolicited $44 billion bid for Yahoo after failing to reach an agreement on price, about restarting deal talks, but that Microsoft didn’t respond. Icahn has bought 50 million Yahoo shares since Microsoft withdrew its bid, which perhaps helps to explain why Yahoo shares haven’t fallen back to preproposal levels since the bid got yanked. If history is any guide, we should soon hear Icahn’s views on Yahoo’s situation and the failings of its top officials in great detail.

Legg Mason (LM) is reeling. The Baltimore-based asset manager swung to a first-quarter loss of $256 million, or $1.81 a share, from the year-ago profit of $173 million, or $1.19 a share. The latest quarter was hit by $206 million in charges tied to the company’s decision to support money-market funds that suffered losses after they invested in illiquid structured debt, and a $95 million hit in a wealth management unit. Revenue fell 6% from a year ago to $1.07 billion. Analysts were looking for a 27-cent loss on revenue of $1.12 billion.

“This past quarter was among the most difficult we have ever faced and we are disappointed with our results,” said CEO Mark Fetting. “We remain a fundamentally strong firm today, but we know we have work to do.”

Indeed, assets under management fell 5% from a year ago to $950 billion, as the company’s portfolio suffered market losses of $28 billion and customer cash outflows of $19 billion.  Equity outflows were $17 billion and fixed income outflows were $7 billion for the quarter, while liquidity inflows totaled $5 billion.

“We have major managers who are performing very well in a tough investment climate, and we are seeing growth outside the U.S.,” Fetting said, “but we know that we need our U.S. equity managers to return to form, and this is a top priority.”

Among the managers who need to return to form is Legg Mason Value Trust manager Bill Miller, whose fund lost 20% of its value in the first quarter after bad bets on struggling financial firms such as Bear Stearns (BSC) and Countrywide (CFC). The losses haven’t curbed Miller’s appetite for publicity, however. A day after he called on Yahoo (YHOO) to buy back stock, he told Bloomberg in an interview that he expects Microsoft (MSFT) to come back to the table with a new offer for the Internet giant - though perhaps not for a while. “If I’m sitting in their shoes, I’ll go away and see what happens,” Miller said of Microsoft. “I can come back and the worst case is, I’ll pay six months more of my free cash flow.” 

Monday’s selloff in Yahoo (YHOO) is creating more pain for value manager Bill Miller. Miller is chief investment officer at Legg Mason Capital Management, which at Dec. 31 was Yahoo’s second-biggest shareholder, with a 6.9% stake, according to Lionshares.com. Yahoo had been one of the standout performers in Miller’s Legg Mason Value Trust, which lost 20% of its value in the first quarter as big bets on beaten-down financial stocks such as Bear Stearns (BSC) went sour. But Monday’s 14% decline in Yahoo takes the stock about half the way back to where it was trading before Microsoft (MSFT) unveiled its $31-a-share bid on Feb. 1. Should they stick, Monday’s declines will reduce the fund’s gains in Yahoo accordingly.

Miller indicates in an interview with The New York Times that he’s surprised by Microsoft’s decision to walk away from Yahoo, and eager to see Yahoo do something to justify shareholders’ patience. He wants to see CEO Jerry Yang turn some of Yahoo’s cash holdings toward a share buyback, he says in the interview. “It would be almost incoherent not to do so,” Miller said. “You can’t maintain that $33 undervalues your company, have your stock trade below that, and not buy back stock.”

Despite the Yahoo selloff and Monday’s decline in another big Legg Mason holding, Countrywide (CFC), Miller’s doing better in the second quarter. He noted two weeks ago in his first-quarter letter to Value Trust shareholders that the fund was ahead of the S&P, and a look at Legg Mason’s biggest holdings as of March 31 shows that only two of his top 10 stocks - UnitedHealth (UNH) and General Electric (GE) - are down this quarter. “I think we will do better from here on,” Miller wrote on April 23, “and that by far the worst is behind us.” So far, so good.

Yahoo (YHOO) shareholders aren’t happy. Shares of the Internet search giant dropped 21% in Frankfurt as trading resumed following the company’s decision to reject a sweetened $33-a-share buyout proposal from Microsoft (MSFT). Yahoo said it wanted $37 a share, a demand that Microsoft chief Steve Ballmer dismissed as too rich. The decision will put Yahoo CEO Jerry Yang under renewed scrutiny, and raises the question of what Microsoft will do next as well. But for now, Microsoft shares are up 4% overseas - meaning Ballmer, at least, isn’t under pressure this very moment.

Yahoo (YHOO) and Microsoft (MSFT) are going their separate ways. Microsoft withdrew its proposal to acquire Yahoo Saturday, after the sides failed to reach an agreement on price. Microsoft, which surprised Yahoo three months ago by going public with an unsolicited cash-and-stock bid worth $31 a share, raised the ante to $33 this weekend but then folded after Yahoo demanded $37. Many observers had expected a deal to get done around $35 a share, so Yahoo’s insistence on a higher figure will raise some eyebrows in coming days.

Microsoft chief Steve Ballmer questioned Yahoo’s decision to demand more money, noting that Microsoft’s revised proposal would have given Yahoo shareholders a 70% premium to their shares’ trading price as of Jan. 31, the day before Microsoft floored tech watchers by unveiling its $44.6 billion bid. “I still believe even today that our offer remains the only alternative put forward that provides your stockholders full and fair value for their shares,” Ballmer wrote in a letter to Yahoo CEO Jerry Yang. “By failing to reach an agreement with us, you and your stockholders have left significant value on the table.”

Ballmer also criticized Yahoo’s decision to consider outsourcing some of its search business to rival Google (GOOG), and suggested that only this week did he appreciate the lengths Yahoo would travel to avoid a Microsoft deal. “I feel that our discussions this week have been particularly useful, providing me for the first time with real clarity on what is and is not possible,” Ballmer said. “After giving this week’s conversations further thought, it is clear to me that it is not sensible for Microsoft to take our offer directly to your shareholders.”

By walking away, Microsoft will put pressure on Yahoo to show its shareholders why they should stick around to watch Yahoo struggle to keep pace with Google. While Yahoo says it remains “steadfast in our belief that Microsoft’s offer undervalued the company, and we are pleased that so many of our shareholders joined us in expressing that view,” the question now is how understanding Yahoo shareholders will be on Monday, when the company’s stock opens for trading without the Microsoft proposal off the table.

Yahoo’s (YHOO) hand looks a lot stronger today than it did just a few days ago. The Internet company is in discussions with Time Warner (TWX), publisher of Fortune, for a deal that would give Yahoo control of AOL and Time Warner a stake in Yahoo, according to The Wall Street Journal.

Under the possible Yahoo-AOL deal, Time Warner would put some cash into Yahoo and get a 20% stake in the combined Yahoo-AOL. Yahoo would then buy back billions of dollars in stock in a bid to support its share price, which is likely to fall if Microsoft’s $31-a-share bid is pulled. The deal comes just a day after Yahoo unveiled a deal to test out a combination of its search ad business with Google’s (GOOG).  

But Microsoft (MSFT), which has been pursuing Yahoo for more than two months, isn’t standing still either: The New York Times reports it is talking with Myspace owner News Corp. (NWS) about a joint bid for Yahoo. Some investors expect the AOL talks to only strengthen Microsoft’s resolve to complete the deal - and to lead to the higher price Yahoo chief Jerry Yang has been demanding.

“Yahoo is a strategic necessity for Microsoft,” Gamco Investors portfolio manager Larry Haverty told Bloomberg television. “Microsoft cannot allow this deal to happen,” he added, referring to a possible AOL-Yahoo tie-up. He expects Microsoft to raise its bid and says he believes a fair value for Yahoo to Microsoft is $35 a share. The AOL talks, he concludes, have “raised the floor” on Yahoo stock. Yahoo shares rose modestly in early trading Thursday, rising 42 cents to $28.19.

Yahoo (YHOO) shares fell 6% in after-market trading Friday after Reuters reported Microsoft (MSFT) is “evaluating” its $42 billion offer for the Internet company. The news agency cited a person familiar with the matter.

The comments, which suggest Microsoft is considering walking away should Yahoo fail to agree to terms, come on the heels of reports that executives at the two tech titans met this week but failed to reach an agreement on the cash-and-stock offer. Microsoft’s worried that a slowing economy and changes in Yahoo’s business stand to lower its value, Reuters reports.

Yahoo’s top brass is to meet Monday to discuss the situation, CNBC reports. It seems unlikely that either side would let the deal collapse at this point, given Microsoft’s strategic challenges in competing with Google (GOOG) and the apparent failure of Yahoo to attract any rival bidders. But Friday’s late action shows that Yahoo shareholders, who have seen the value of their investment jump 48% since Microsoft unveiled its offer on Feb. 1, are starting to get nervous.