'Only when there are no capable products will the Chinese government consider foreign offerings,' Ms Liu said in a research note.

Kingsoft software packages are designed to operate on computers running the Microsoft Windows operating system, but Ms Liu said the company was preparing Linux versions for release by the end of the year.

Washington-based Microsoft is said to have been one of the bidders for the contract and Ms Liu saw the award as a blow for the company. Microsoft's Office software suite is estimated to run on 95 per cent of China's desktops, though many of those copies are thought to be pirated and Microsoft does not release revenue figures for the mainland.

The company lost out on another software contract put out for bidding by the Beijing provincial government at the end of last year, but it has countered by announcing a new investment in China worth 6.2 billion yuan and a contract with the State Council.

'This is the second time indigenous vendors have won the government purchasing bidding over Microsoft. Although Microsoft has learnt from its failure in the Beijing government software purchasing bidding [at the] end of 2001, and initiated several big moves to soften the relationship with the Chinese government, including establishing the JVs, promising technology transfer, donating to found training centres, and even making source code available, it seems that Microsoft will still be greatly challenged on how to strengthen its position in China,' Ms Liu's note said.

Microsoft officials could not be reached for comment.

The question of whether to favour local software vendors is becoming a significant one as China's software market continues to grow and government is expected to continue as one of the country's largest consumers of information technology. Ms Liu estimated the government had spent 15.5 billion yuan on information technology in the first half of the year.

'Although this may have negative effect on the foreign investment zest, there are still plenty of opportunities for foreign vendors,' she said, adding that those who wanted to thrive in the market should collaborate with local partners and develop closer relationships with government offices.

Separately, a delegation to next week's LinuxWorld trade show in San Francisco is reportedly set to announce that the government plans to push the use of Linux on network servers.

The Beijing contracts awarded last year also included the purchase of the Red Flag Linux operating system and Linux applications from other vendors. The government has long been open about its backing of the open-source operating system, partly for the fact that its source code can be seen, thus allaying the government's fears that secret back doors might be installed on the nation's computers.

China also sees the fact that the kernel, or the core of the software, is available free as an advantage in its efforts to quickly modernise the country.

Linux is an open-source operating system which competes on servers with Sun's Solaris, HP's True64 and Microsoft Windows.

Sources say Windows still commands a large chunk of the mainland server market.

Some enthusiasts have also pushed Linux for the desktop, where Windows has a 90 per cent market share worldwide. Last year's Beijing contract included Chinese-made office and anti-virus software for desktops running on Linux.

Governments with large Linux projects include those of Taiwan, South Korea, France, Spain and Germany. The mainland's post office is a government department using Linux. In the United States the Department of Energy runs Linux as do several French ministries. Peru has proposed legislation that would require the use of open-source software in government projects.

In Hong Kong, the government is using Linux on a small number of servers.