When the original Xbox video-game console went on sale in 2001, it wasn’t clear why Microsoft, known for staid workplace software, was branching out into fast-paced action games. But Microsoft decided that capitalizing on the popularity of gaming could help the company position itself for the coming wave of home digital entertainment.

“Microsoft saw the writing on the wall,” says David Dennis, a spokesman for Xbox. “It wanted to have a beachhead in the living room.” Ten years later, the Xbox 360 is currently the second best-selling video-game system in the United States, according to market research firm NPD, behind Nintendo’s Wii and beating out Sony’s PlayStation3, and making Microsoft a contender in the fierce battle to serve up entertainment on demand, especially from Internet video services. Analyst firm BCC Research estimates that $144 billion was spent on “digital living room” devices worldwide in 2010, and that this figure will grow to $226 billion by 2015.

In 2000, Microsoft looked like an unlikely competitor to Sony and Nintendo, which had built console gaming into a billion-dollar industry. Although it had dabbled in PC games, its entire business model revolved around Windows, Office, and other software for enterprises. Its hardware division produced mice and some other peripherals, not sophisticated consumer electronics.

Still, Microsoft was sitting on nearly $5 billion in cash. It could afford an experiment that even in the best case would be a money loser for years, says Rob Sanfilippo, a former Xbox developer at Microsoft who now is an analyst at Directions on Microsoft, a research firm. (In fact, Microsoft did lose money on the Xbox for the first six years. In total, the divisions that housed the Xbox from 2002 through 2007 lost about $7.5 billion, according to regulatory filings, before posting an operating profit of $426 million in the 2008 fiscal year.) The Xbox was designed to play to Microsoft’s corporate strengths, in particular building tools and support for the programmers who would actually make the games.

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Crucially, Microsoft also leveraged its networking experience, adding an Ethernet port to every Xbox as standard. In 2002, the company launched its Internet-based Xbox Live service, which made it easy for people to play against online opponents. This put Microsoft ahead of Sony and Nintendo, which did not make networking a standard feature of their consoles until 2004 in Sony’s case and 2006 in Nintendo’s.

As the Xbox gave way to the Xbox 360, and Sony and Nintendo also brought out new hardware platforms (the PlayStation 3 and the Wii), Microsoft’s handling of its online service continued to distinguish it from its rivals. Unlike Sony and Nintendo, Microsoft was quick to embrace the idea of using its hardware to offer content from many partner sources, from games created by external developers to video from Netflix and Hulu. Recently, Microsoft announced a deal with cable providers such as Comcast and cable networks such as HBO to funnel pay TV through the Xbox 360 console instead of dedicated cable boxes.

Of course, Microsoft isn’t alone in combining television, movies, music, and Web content. Cable and satellite providers, television manufacturers, set-top box makers such as Roku, and Apple and Google are all now competing for a share of the digital living-room market. But thanks to the Xbox 360’s start as a video-game console, Microsoft’s 57 million console owners and 35 million Xbox Live members worldwide give the company a large established base of users to build on. Meanwhile, Apple and Google have struggled to sell their narrowly focused TV products (see “Searching for the Future of Television,” January/February 2011).

Now Microsoft is linking Xbox 360, its most successful consumer-focused brand, with others that have not been as well received. It is integrating Bing, its search engine, into Xbox and Xbox Live to enable people to search for multimedia content. By the end of the year, Microsoft is expected to unveil an updated Xbox Live design that is more in line with the look of Windows phones and the forthcoming Windows 8.

The future, says Microsoft’s Dennis, will involve seamless transitions between phones, PCs, and the Xbox: “You start a movie on a desktop or a big TV and finish it on a laptop, [or you] want to watch at your desk while you’re having lunch. We’re creating a media system [with pieces] that can all talk to each other.”