Microsoft continued to make strategic decisions directed at consumers. The company released Microsoft Bob, a graphical user interface designed for novice computer users, in March 1995. The interface was discontinued in 1996 due to poor sales; Bill Gates later attributed its failure to hardware requirements that were too high for typical computers, and is widely regarded as one of Microsoft's most unsuccessful products. DreamWorks SKG and Microsoft formed a new company, DreamWorks Interactive (in 2000 acquired by Electronic Arts which named it EA Los Angeles), to produce interactive and multimedia entertainment properties. On August 24, 1995, Microsoft released Windows 95, a new version of the company's flagship operating system which featured a completely new user interface, including a novel start button; more than a million copies were sold in the first four days after its release.

Windows 95 was released without a web browser as Microsoft had not yet developed one. The success of the web caught them by surprise and they subsequently approached Spyglass to license their browser as Internet Explorer. Spyglass went on to later dispute the terms of the agreement, as Microsoft was to pay a royalty for every copy sold. However, Microsoft sold no copies of Internet Explorer, choosing instead to bundle it for free with the operating system.

Internet Explorer was first included in the Windows 95 Plus! Pack that was released in August 1995. In September, the Chinese government chose Windows to be the operating system of choice in that country, and entered into an agreement with the company to standardize a Chinese version of the operating system. Microsoft also released the Microsoft Sidewinder 3D Pro joystick in an attempt to further expand its profile in the computer hardware market.

On May 26, 1995, Bill Gates sent the "Internet Tidal Wave" memorandum to Microsoft executives. The memo described Netscape with their Netscape Navigator as a "new competitor 'born' on the Internet". The memo outlines Microsoft's failure to grasp the Internet's importance, and in it Gates assigned "the Internet the highest level of importance" from then on. Microsoft began to expand its product line into computer networking and the World Wide Web. On August 24, 1995, it launched a major online service, MSN (Microsoft Network), as a direct competitor to AOL. MSN became an umbrella service for Microsoft's online services, using Microsoft Passport (now called a Microsoft account) as a universal login system for all of its web sites. The company continued to branch out into new markets in 1996, starting with a joint venture with NBC to create a new 24-hour cable news television station, MSNBC. The station was launched on July 15, 1996, to compete with similar news outlets such as CNN. Microsoft also launched Slate, an online magazine edited by Michael Kinsley, which offered political and social commentary along with the cartoon Doonesbury. In an attempt to extend its reach in the consumer market, the company acquired WebTV, which enabled consumers to access the Web from their televisions. Microsoft entered the personal digital assistant (PDA) market in November with Windows CE 1.0, a new built-from-scratch version of their flagship operating system, designed to run on low-memory, low-performance machines, such as handhelds and other small computers. 1996 saw the release of Windows NT 4.0, which brought the Windows 95 GUI and Windows NT kernel together.

While Microsoft largely failed to participate in the rise of the Internet in the early 1990s, some of the key technologies in which the company had invested to enter the Internet market started to pay off by the mid-90s. One of the most prominent of these was ActiveX, an application programming interface built on the Microsoft Component Object Model (COM); this enabled Microsoft and others to embed controls in many programming languages, including the company's own scripting languages, such as JScript and VBScript. ActiveX included frameworks for documents and server solutions. The company also released the Microsoft SQL Server 6.5, which had built-in support for internet applications. In November 1996, Microsoft Office 97 was released, which is the first version to include Office Assistant. In 1997, Internet Explorer 4.0 was released, marking the beginning of the takeover of the browser market from rival Netscape, and by agreement with Apple Computer, Internet Explorer was bundled with the Apple Macintosh operating system as well as with Windows. Windows CE 2.0, the handheld version of Windows, was released this year, including a host of bug fixes and new features designed to make it more appealing to corporate customers. In October, the Justice Department filed a motion in the federal district court in which they stated that Microsoft had violated an agreement signed in 1994, and asked the court to stop the bundling of Internet Explorer with Windows.

The year 1998 was significant in Microsoft's history, with Bill Gates appointing Steve Ballmer as president of Microsoft but remaining as Chair and CEO himself. The company released an update to the consumer version of Windows, Windows 98. Windows 98 came with Internet Explorer 4.0 SP1 (which had Windows Desktop Update bundled), and included new features from Windows 95 OSR 2.x including the FAT32 file system, and new features designed for Windows 98, such as support for multiple displays. Microsoft launched its Indian headquarters as well, which would eventually become the company's second largest after its U.S. headquarters. Finally, a great deal of controversy took place when a set of internal memos from the company were leaked on the Internet. These documents, colloquially referred to as "The Halloween Documents", were widely reported by the media and went into detail of the threats that free software / open source software poses to Microsoft's own software, previously voiced mainly by analysts and advocates of open source software. The documents also alluded to legal and other actions against Linux as well as other open source software. While Microsoft acknowledged the documents, it claimed that they are merely engineering studies. Despite this, some believe that these studies were used in the real strategies of the company.

Microsoft, in 2000, released new products for all three lines of the company's flagship operating system, and saw the beginning of the end of one of its most prominent legal cases. On February 17, Microsoft released an update to its business line of software in Windows 2000. It provided a high level of stability similar to that of its Unix counterparts due to its usage of the Windows NT kernel, and matching features found in the consumer line of the Windows operating system including a DOS emulator that could run many legacy DOS applications.

On April 3, 2000, a judgment was handed down in the case of United States v. Microsoft Corp., calling the company an "abusive monopoly" and forcing the company to split into two separate units. Part of this ruling was later overturned by a federal appeals court, and eventually settled with the U.S. Department of Justice in 2001. On June 15, 2000, the company released a new version of its hand-held operating system, Windows CE 3.0. The main change was the new programming APIs of the software. Previous versions of Windows CE supported only a small subset of the WinAPI, the main development library for Windows, and with Version 3 of Windows CE, the operating system now supported nearly all of the core functionality of the WinAPI. The next update to the consumer line, Windows ME (or Windows Millennium Edition), was released on September 14, 2000. It sported several new features such as enhanced multimedia abilities and consumer-oriented PC maintenance options, but is often regarded as one of the worst versions of Windows due to stability problems, restricted real mode DOS support and other issues.

Microsoft released Windows XP and Office XP in 2001, a version that aimed to encompass the features of both its business and home product lines. The release included an updated version of the Windows 2000 kernel, enhanced DOS emulation abilities, and many of the home-user features found in previous consumer versions. XP introduced a new graphical user interface, the first such change since Windows 95. The operating system was the first to require Microsoft Product Activation, an anti-piracy mechanism that requires users to activate the software with Microsoft within 30 days. Later, Microsoft would enter the multibillion-dollar game console market dominated by Sony and Nintendo, with the release of the Xbox. The Xbox finished behind the dominant PlayStation 2 selling 24 million units compared to 155 million overall; however they managed to outsell the GameCube which sold 21 million units. Microsoft launched their second console, the Xbox 360, in 2005 – which was more successful than the original. By 2017 the Xbox 360 had sold 84 million units but failed to outsell its main rival the PlayStation 3 which sold 87 million units when discontinued. The console was also outsold by the Wii which introduced gesture control and opened up a new market for video games. Microsoft later used their popular controller-free Kinect peripheral to increase the popularity of the Xbox. This was very successful. As of 2011 Kinect was the fastest selling consumer electronics product in history. It sold 8 million units from November 4, 2010, to January 3, 2011, (its first 60 days). It averaged 133,333 units per day, outselling the iPhone and iPad over equivalent post-launch periods.

In 2002, Microsoft launched the .NET initiative, along with new versions of some of its development products, such as Microsoft Visual Studio. The initiative has been an entirely new development API for Windows programming, and included a new programming language, C#. Windows Server 2003 was launched, featuring enhanced administration abilities, such as new user interfaces to server tools. In 2004, the company released Windows XP Media Center Edition 2005, a version of Windows XP designed for multimedia abilities, and Windows XP Starter Edition, a version of Windows XP with a smaller feature set designed for entry-level consumers. However, Microsoft encountered more turmoil in March 2004 when antitrust legal action would be brought against it by the European Union for allegedly abusing its market dominance (see Microsoft Corp v Commission). Eventually Microsoft was fined €497 million (US$613 million), ordered to divulge certain protocols to competitors, and to produce a new version of its Windows XP platform—called Windows XP Home Edition N—that did not include its Windows Media Player. Microsoft was also ordered to produce separate packages of Windows after South Korea also landed a settlement against the company in 2005. It had to pay out US$32 million and produce more than one version of Windows for the country in the same vein as the European Union-one with Windows Media Player and Windows Messenger and one without the two programs.

In guise of competing with other Internet Companies such as the search service Google, in 2005 Microsoft announced a new version of its MSN search service. Later, in 2006, the company launched Microsoft adCenter, a service that offers pay per click advertisements, in an effort to further develop their search marketing revenue. Soon afterward, Microsoft created the CodePlex collaborative development site for hosting open source projects. Activity grew quickly as developers from around the world began to participate, and by early 2007 commercial open source companies, such as Aras Corp. began to offer enterprise open source software exclusively on the Microsoft platform.

On June 15, 2006, Bill Gates announced his plans for a two-year transition period out of a day-to-day role with Microsoft until July 31, 2008. After that date, Gates will continue in his role as the company's chairman, head of the board of directors and act as an adviser on key projects. His role as Chief Software Architect will be filled immediately by Ray Ozzie, the Chief Technical Officer of the company as of June 15, 2006. Bill Gates stated "My announcement is not a retirement – it's a reordering of my priorities".