ATI said it entered a technology agreement with Microsoft to develop "custom, leading-edge graphics technologies" for the console.
"We selected ATI after reviewing the top graphics technologies in development and determining that ATI's technical vision fits perfectly with the future direction of Xbox," Robbie Bach, senior vice president of Microsoft's home and entertainment division, said in a statement.
The announcement ends months of speculation over whether Nvidia, the leading maker of graphics processors for PCs, would renew its troubled partnership with Microsoft on the Xbox. The graphics processor is the most expensive component in the Xbox, and Nvidia stood poised for a major windfall after the chipmakershortly after the Xbox was announced three years ago.
But sales problems and hardware changes left Nvidia with piles of unsold and unusable chips, putting it in a position where it could have lost money on the console if it hadn't.
The Xbox deal has accounted for 15 percent to 20 percent of Nvidia's sales over the past two years, and company executives credited Xbox-related business for aduring Nvidia's most recent quarter.
Analysts had predicted the contract for the next Xbox might go to ATI, which also makes the graphics processor for Nintendo's GameCube. They attributed the predictions partly due to lack of interest from Nvidia.
"Nvidia has really given a lot of signals...that they're trying to distance themselves from Xbox2," Michael McConnell, an analyst for Pacific Crest Securities, said earlier this summer. "That relationship has really soured over the last year...Microsoft in general is just not a very nice partner to deal with. I think the whole experience left Nvidia with a bad taste in their mouth."
Microsoft has yet to set a date or reveal details on the successor to the current Xbox, despitefrom fans and game makers. While Microsoft will need to deliver new technology that can compete with Sony's successor to the PlayStation 2, it is also likely looking for ways to cut costs after .
Financial terms of the new deal were not disclosed, but Rick Bergman, senior vice president of marketing for ATI, confirmed that the contract includes a royalty arrangement that will protect ATI from the type of inventory problems that hampered Nvidia.
Bergman hailed the partnership as a sign of ATI's growing influence beyond the PC.
"If you want to play in consumer electronics, the game market is absolutely critical, and this really puts us at the forefront there," he said.