Updated from 10:10 a.m. EST

Dealing what could be a fatal blow to the hostile takeover bid, the Department of Justice and seven states will file suit to block

Oracle's

(ORCL) - Get Report

bold offer for rival

PeopleSoft

(PSFT)

.

Despite lobbying by Oracle, Assistant Attorney General R. Hewitt Pate has decided to stand by his staff's recommendation to block the second-largest software maker's $9.4 billion bid for PeopleSoft, the department announced Thursday. Attorneys general from Hawaii, Maryland, Massachusetts, Minnesota, New York, North Dakota and Texas are joining the lawsuit, which will be filed in U.S. District Court in San Francisco on Thursday.

"We believe this transaction is anticompetitive -- pure and simple," Pate said in a press release.

"If the merger were allowed to proceed, it would eliminate competition between two of the nation's leading providers of human resource and financial management enterprise software applications, resulting in higher prices, less innovation and fewer choices for the businesses, government agencies, and other organizations that depend on this type of software," the department said in the release.

Friday morning, shares of PeopleSoft were recently down 67 cents, or 3.1%, to $21.11; Merrill Lynch downgraded its recommendation to sell from neutral in the wake of the DOJ's decision. Oracle was recently down 9 cents, or 0.7%, to $13.19.

In a prepared statement Thursday, PeopleSoft CEO Craig Conway called on Oracle to give up its fight, noting that his company has consistently said the acquisition would be prohibited under antitrust rules.

Shortly after Oracle launched the hostile takeover last June, Ellison said the deal would be dead if antitrust regulators opposed it. But more recently he said he would fight for the deal in court and has reportedly been talking to Oracle's board about winning its approval to wage that battle.

Late Thursday, Oracle announced the company will indeed fight the DOJ suit.

"We believe that the government's case is without basis in fact or in law, and we look forward to proving this in court," Jim Finn, an Oracle spokesperson, said in a statement.

Oracle's Board of Directors has met and decided to "vigorously challenge the Justice Department's lawsuit to block Oracle's merger with PeopleSoft," the statement continued. "The Department's claim that there are only three vendors that meet the needs of large enterprises does not fit with the reality of the highly competitive, dynamic and rapidly changing market."

Since the litigation will likely extend beyond PeopleSoft shareholders' meeting on March 25, Oracle also announced the withdrawal of the slate of directors it nominated for PeopleSoft's board. Oracle will now not solicit proxies for use at the meeting. However, Oracle has extended its previously announced tender offer for all PeopleSoft stock to 12:00 a.m. EST on June 25.

Larry Vs. Uncle Sam

In a presentation to investors filed with the

Securities and Exchange Commission

this week, Oracle said it believes "it has a very strong case and will ultimately prevail. Efficiencies created by the merger far outweigh any purported anticompetitive harm."

But after several months of review, Justice Department regulators disagreed. The DOJ concluded that Oracle, PeopleSoft and German behemoth

SAP

(SAP) - Get Report

are the only companies that currently compete to develop and sell the high-function integrated human resource management and financial management services software for large enterprises.

"This lawsuit seeks to ensure that there will continue to be vigorous competition in this important industry," Pate said.

Antitrust experts and financial analysts had predicted that Oracle would be blocked if Justice Department regulators use a narrow definition of the application software market. A wider definition, by contrast, would have included competitors such as

Microsoft

(MSFT) - Get Report

that are slowly expanding into the enterprise space, as well as more specialized players such as

Siebel Systems

(SEBL)

and

i2 Technologies

(ITWO)

that concentrate on specific areas such as customer-relationship management and supply-chain software.

Oracle will be going against the grain in fighting the DOJ. "It is not common for somebody to make the government take them to court in a merger case," said Paul Friedman, who co-chairs the antitrust group of the Washington, D.C., law firm Dechert LLP. There are cases where the government has lost in court, Friedman added, though he could not cite a specific example.

The government has the burden to prove the merger is anticompetitive, but "one should expect that the government is pretty confident that they've got the evidence to support their claim," Friedman added. "I am confident that the government had substantial evidence -- primarily from customers who feared that an Oracle acquisition of PeopleSoft would limit their choices and result in higher prices."

Investors, meanwhile, prefer Oracle throw in the towel rather than be distracted by a protracted legal battle. "My preference would be ... that they probably just move ahead and operate their business," said Marty Shagrin, a software analyst with Victory Capital Management in Cleveland, which has small holdings of Oracle and PeopleSoft. "I'm not sure it's time well-spent fighting a case in court trying to acquire a company that doesn't want to be acquired."

FTN Midwest Research analyst Trip Chowdhry said he believes Oracle should and will abandon its bid for PeopleSoft rather than fight the DOJ.

"To win against the DOJ is going to be a very long process, and I don't think Oracle will serve its customers well by proceeding with the bid against the DOJ and getting distracted further," said Chowdhry, who has a buy rating on Oracle and neutral rating on PeopleSoft. Instead, he predicts Oracle will focus on its own applications business and look for other acquisitions in the applications space. (FTN Midwest Research does not have an investment banking business.)

Ellison already has thrown out

BEA Systems

as one possible acquisition target if the price were right. Other

potential acquisitions that would help Oracle move beyond its core, maturing database market could include a business intelligence software maker such as

(HYSL)

or an industry-specific software maker such as

Retek

(RETK)

.

The PeopleSoft board has steadfastly rebuffed Oracle's overtures, saying Oracle's price was too low each of the three times the company raised its bid. PeopleSoft executives also have said its company is more valuable on its own, and cited a slow antitrust review as a reason to oppose Oracle's move.

Investors, meanwhile, started taking Oracle more seriously after its last move sweetening its bid to $26 a share, a premium over its current trading price. Shagrin called the latest price a "compelling offer" for PeopleSoft shareholders. "I thought the $26 price was a pretty fair price," he said. But "it doesn't look like we're going to get a chance to see if that price would have been enough to get that deal done."

In explaining his downgrade to sell, Merrill Lynch analyst Jason Maynard wrote that while the DOJ's decision was not surprising and that the deal might be revived given Oracle's legal challenge, PeopleSoft shares "no longer have a floor, and the stock has material downside given our execution concerns."

These concerns include skepticism about the predicted "revenue synergies" from the J.D. Edwards merger and a belief the "PeopleSoft 8 product cycle has been played out, and that cross-sell opportunities are not meaningful."

For those reasons, "we expect that PeopleSoft will likely need to make downward revisions to its license revenue guidance," Maynard wrote.