The albatross weighing down merchant energy stocks lightened some on Friday.

The sector, hammered for months over potential liabilities in California, bounced on favorable news from the Federal Energy Regulatory Commission. FERC judge Bruce Birchman decided that 10 energy companies accused of overcharging California for power by $9.1 billion during the 2000-2001 energy crisis should pay the state only $1.8 billion in refunds. Because California still owes the companies $3 billion for power it never paid for, the energy traders could come out of the deal $1.2 billion ahead.

The recommendation, described as preliminary, still needs approval from the full FERC. California Gov. Gray Davis has already expressed outrage at the "pittance" energy companies would refund his state under the proposal, and has vowed to appeal the decision if it's finalized.

But if approved, the settlement would be a godsend for battered energy merchants hoping to put their worst nightmares -- centered in California -- behind them. Investors in the sector, clearly braced for much worse, rushed to celebrate the news.

The biggest boost went to a company that, perhaps, needed it most. Shares of Dynegy ( DYN) soared 18% to $1.06 on hopes for the FERC recommendation, which would net Dynegy $125 million even after paying a $177 million refund. The stock, which sank below the $1 mark on Thursday, is in danger of being delisted by the New York Stock Exchange if it cannot retain a minimum $1 share price.

Debt-laden Reliant Resources ( RRI) tacked on the second-largest percentage gain. The company, which would net $154 million under the proposed FERC deal, climbed 15% to $2.59 in midday trading.

Williams ( WMB) enjoyed a similar rally, jumping 11% to $2.59. The FERC judge has recommended that Williams repay California $192 million -- more than any other company -- but the ruling would still leave Williams $55 million in the black.

Even Enron, the industry's poster child for alleged trading manipulation, would squeak out a small gain from the FERC deal. The FERC judge estimated that California owes Enron $43.4 million -- or $400,000 more than Enron should refund the state.

Meanwhile, Duke ( DUK) would net $194 million -- the largest gain in the sector -- after paying a $71.5 million refund. But the company, hit by concerns about its credit, missed out on Friday's rally. The stock slipped 2% to $18.92 after Standard & Poor's revised the outlook for Duke's credit, currently rated A, from stable to negative. S&P cited worries about Duke's cash flow and overall industry weakness as the reasons for its action.

Despite the market's general celebration Friday, the California energy controversy is far from resolved. Many energy companies are still struggling to renegotiate long-term power contracts signed at the height of the California energy crisis. The new contracts, such as one recently hammered out by Williams, are expected to offer far less favorable terms for the companies.

Meanwhile, El Paso ( EP) still stands accused of contributing to California's energy woes by withholding critical capacity from its natural gas pipeline. And other companies have been similarly accused of manipulating natural gas prices.