Updated from 5:43 p.m. EDT

New York's bulldog Attorney General Eliot Spitzer, whose aggressive investigations have shaken firms such as

Merrill Lynch

(MER)

and

American International Group

(AIG) - Get Report

, is now taking aim at the Web.

The attorney general's office is suing

Intermix Media

(MIX)

, a Los Angeles-based company that runs a network of Web sites and marketing services, for secretly installing its spyware onto millions of computers in New York.

"We tested a lot of sites for spyware, and Intermix was one of the worst offenders," says Justin Brookman, an attorney in the Internet Bureau of Spitzer's office. "This is a shot across the bow to the rest of industry and to companies that advertise through the them. This is a warning that liability is across the board."

Spyware has ranked second only to spam in Internet annoyances, resulting in everything from pop-up ads to hijacking browsers and from collecting private data to causing countless computer crashes.

The news shakes Intermix in the midst of a

delicate turnaround. Under new CEO Richard Rosenblatt, who had founded and sold off two successful start-ups and shepherded drkoop.com through its postbankruptcy period, Intermix had been hoping to catch the attention of a lot more customers and investors. But it couldn't have imagined it would get attention this way.

Intermix's stock fell 83 cents, or 17%, to $3.97 Thursday after falling as low as $3.22. Volume of 3.3 million shares was nearly 10 times the average daily volume for the microcap stock. Intermix shares had been steadily gaining in recent months, climbing to a high of $9.20 in March from $2 last summer.

Rosenblatt took control of Intermix in February 2004 after the previous management, led by founder Brad Greenspan, had steered the company into rough waters. In 2003, the company restated $39 million in revenue and was delisted from

Nasdaq

. Under Rosenblatt, the company shed many of its controversial and unprofitable businesses, was renamed Intermix (from eUniverse) and found a new listing on the American Stock Exchange.

But according to Spitzer's office, Intermix continued, until at least late last year, to bundle spyware with the games and other features it allowed visitors to its sites to download at no charge. And the suit filed Thursday turns Intermix into the poster child for spyware, a publicly traded face to attach to a scourge that has vexed Internet surfers around the world.

In announcing the lawsuit, Spitzer added that spyware undermines productivity and "can serve as a hindrance of growth to e-commerce."

Spy-Proofing

Spitzer's petition seeks to prevent Intermix from installing any more of the applications in question and to account for the programs installed to date. It also seeks repayment of "unjust enrichment" from them as well as penalties and costs.

Intermix says it started installing fewer programs in November, the same month Spitzer's office began to test the alleged spyware for its investigation and has since stopped distributing them altogether. Intermix made $250,000 from the 3.7 million programs downloaded by residents of New York.

But those efforts were hardly seen as mitigating by the attorney general's office. "These downloads occurred from last October through this February on a dozen Intermix sites," said Brookman. "If they wanted to pull the plug on this, they would have had time to do it on their own site."

The lawsuit centers on four programs created by Intermix: KeenValue, which delivers pop-up ads; IncrediFind, which automatically redirects misspelled urls to an Intermix site; Updater, which allows Intermix to update or add functionality to its programs; and toolbars, much like those offered by

Yahoo!

(YHOO)

and

Google

(GOOG) - Get Report

, but which include links to Intermix's services and clients.

Spitzer's office says that, in addition to the computers affected in New York, "tens of millions" of other hard drives house Intermix's secret programs. That could increase Intermix's ultimate payouts exponentially.

Beyond that, the company could be liable for more payments if the marketing side of its business relied on user data collected by spyware. About half of Intermix's revenue comes from the marketing of diet and other products to its members.

Intermix's statement said that the applications in question are not material to its business and are not part of Rosenblatt's vision. But the privacy policy of one of the sites mentioned in the petition, mycoolscreen.com, says Intermix may track online behaviors with its software, "including its desktop software products, in order to increase the effectiveness of the advertisements it delivers.

Examples of such behaviors may include advertisement responses, websites that individuals visit, and products that individuals purchase."

Other sections of mycoolscreen's privacy policy notice warn users that information collected could result in promotional email in their inbox, direct mail in their mailbox and telemarketing calls in their homes.

Whether Intermix's applications constitute spyware -- and fraudulent behavior -- hinges in part on when bundled software becomes spyware. The attorney general's petition notes that Intermix did let users know they were downloading extra programs, but in a way that couldn't reasonably be considered adequate.

"Intermix either fails to disclose these additional programs in any manner, or hides mention of them deep within lengthy, legalistic license agreements," the petition reads. "Even in the latter case, the information Intermix does provide about the spyware programs is vague, incomplete and often factually incorrect."

This may become the crux of the case. Intermix insists it gave adequate notice to users. In its statement, the company said it has, "since the outset, provided a means of removing the applications from the user's desktop in one form or another." Recent versions of the bundled programs allow users to uninstall from the "add/remove" function in Microsoft Windows -- a bit of geek know-how beyond the skill of many Internet surfers.

Intermix also insists it gave disclosure of the redirect applications and other functions of its bundled programs in the user agreement "which users are asked to read prior to consummating a download." But as Spitzer's petition points out, the notice comes in the middle of a long agreement that is "arcane" and "cryptic" in its wording. It also noted that the agreement gave no warning that KeenValue, the pop-up ad software, would be installed.

Intermix also distributed the applications in question to third parties such as

Acez

, another company offering screensavers. A recent

Securities and Exchange Comission

filing shows that Intermix also bundled at least one application through

Sharman Network's

Kazaa Media Desktop, a once-popular file-sharing service.

Intermix gave Sharman half a million shares and $625,000 in cash but canceled the deal last November, apparently after it delivered little of the revenue Intermix expected.