Tech-savvy recipients of an Xbox 360 this season might want to take it apart and solder in a few modification chips, maybe even convert the gaming console into a PC, if past tinkering with the original Xbox is any indication. And consumers with new mobile phones might be looking for someone clever to give them a way to transfer all their contacts from their old phone.

Reverse engineering hardware is a time-honored tradition, made famous in the early days of the semiconductor industry. This coming year, however, there could be more efforts to restrict this practice – a shift that would affect both hackers and general consumers, who might want the freedom to, say, switch between different mp3 players and digital video recorders for their TVs.

Of course, attempts at restricting what can be done with hardware in part have to do with protecting copyrighted material. Last week, for instance, three Californians men were arrested for making and selling Xbox consoles modified to run pirated games, adding to the list of crackdowns under the Digital Millennium Copyright Act (DMCA), a law that, in part, prohibits circumventing copyright protection technology. The Xbox hack was ultimately made possible by reverse engineering the game console’s chip set.

The most disturbing aspect of reverse engineering, however, at least for businesses, is that the concept can easily be linked to hackers and garage cowboys looking to modify their devices without worrying about the law.

But reverse engineering is also essential for companies competing in the semiconductor industry.

Indeed, some firms specialize in analyzing a new technology and selling reports on the results to industry players. Last month, for example, Chipworks, a Canadian reverse-engineering company, announced it had analyzed the key chips of the Xbox 360.

Chipworks has reverse engineered thousands of chips in its 12-year history, according to the company’s senior technology analyst, Dick James. And they sell these reports to all the major manufacturers worldwide, he says.

The company insists what it does is entirely legal, and not just in Canada. Andrea Girones, patent advisor at Chipworks, points to the U. S. Semiconductor Chip Protection Act of 1984, created to protect companies against the copying of chip designs. It contains a section specifying that reverse engineering a competitor’s chips is legal for the purpose of making products compatible with it – or even for producing a better competing product.

A congressional committee report on the act explains that reverse engineering is “an accepted practice in the semiconductor chip industry whereby a competitor studies and analyzes an existing chip in order to try to make an improved or related version.” In short, reverse engineering hardware has been considered legal as long as it didn’t involve copying someone’s chip design.

But the clear-cut legality of hardware reverse engineering is coming to an end. In spite of legal protections, the waters are getting a bit muddier for Chipworks. And new legal challenges, both using the DMCA and those pecking away at the Chip Protection Act, could make things a lot worse.

Already as a result of litigation and new end-user license agreements there are gray areas, according to Jason Schultz, an attorney at the San Francisco-based Electronic Frontier Foundation, a nonprofit legal organization that defends technology companies and consumers. Schultz expects that the coming years will see challenges to reverse engineering, as companies strive to “leverage one product to make you buy another,” by having their hardware be compatible with only certain batteries, remote controls, or other devices.

“As more and more people get mobile devices, cell phones, PDAs, and Treos, the key battleground is going to be how easy it is to shift between them,” Schultz says. “If I have all my music on my iPod and some new music player comes out, I may want to buy that new music player. But the key question is: How easy is it going to be for me to import all of my music?”

Reverse engineering could lead to devices that make switching as easy as pushing a button. The same would be true for digitally recording TV shows, Schultz says, where reverse-engineering-enabled compatibility could be used to transfer the recorded files to any number of devices.

So far, two prominent lawsuits have tried to stop the creation of compatible devices. In both, companies had reverse engineered products, one to produce printer ink cartridges, the other remote controls. The litigation appealed to the DMCA, but the cases were eventually thrown out because judges decided no one was trying to steal copyrighted material.

Although these rulings upheld hardware reverse engineering used to create compatible products, Schultz expects there will be more challenges in the future. Specifically, end-user agreements that prohibit reverse engineering may pose a challenge, bringing contract law in conflict with copyright law. “That’s why it’s murky,” he says. “Different courts have come at it in different ways.”

Making matters even more confusing, national borders often provide little protection. Chipworks, for instance, needs to tread lightly when dealing with U.S. clients. Company patent advisor Girones says they keep an eye out for embedded code, which might be considered copyrightable, and warn their customers when they might be entering murky territory. “We have to be aware of it for our clients. We want to make sure everything’s on the up and up.”

The outcome of the current legal wranglings could have a profound impact. “It’s going to affect consumers directly,” says Schwartz. “The number of choices they’ll have will directly depend on how free reverse engineering is, how [legally] safe it is, because companies aren’t going to invest if they’re going to get sued.”