The commission approved the deal after AOL agreed to sever all structural links with German media group Bertelsmann. The deal still needs to pass regulatory approval in the US.
"The proposed undertakings will prevent AOL from having access to Europe's leading source of music publishing rights, thereby eliminating the risk of dominance in the emerging market for online delivery of music over the Internet and software-based music players," the European Commission said in a statement.
Despite heavy lobbying by Walt Disney, the commission said that the merger does not raise concerns with respect to the European Internet broadband access market. The commission's concerns focused solely on the music industry.
"In a music market already characterised by a high degree of consolidation the danger, which has been averted, was that by allowing AOL to team up effectively with three of the five music majors, the resulting company could have dominated the online music distribution market and the market for music players," said European Commissioner for Competition Mario Monti.
He explained that AOL would have had links with Bertelsmann's music unit BMG, and with Warner Music and EMI. The other two majors he referred to are Universal and Sony Music.
The commission said AOL and Bertelsmann have put in place a mechanism by which Bertelsmann will progressively exit from AOL Europe, in which it holds a 50 per cent stake. Bertelsmann will also pull out of AOL Compuserve France, its joint venture with AOL and Vivendi subsidiaries Cégétel and Canal+.
Without that break from Bertelsmann, AOL Time Warner would have controlled the leading source of music publishing in Europe, as Bertelsmann and Time Warner together hold approximately one third of the European market in music publishing, the commission said.
"Against this background, nothing would have prevented AOL from dominating the emerging market for Internet music delivery online, which includes both digital downloads and streaming," the commission said, adding, "AOL Time Warner would have become the gatekeeper to this nascent market."
Industry observers underlined the importance of getting such controls right first time.
"You could possibly look at AOL as the potential Microsoft of that industry, now it's beginning to merge with partners like this ... the people with the infrastructure are looking for high-profile content providers," said analyst Nicky Walton of International Data Corp (IDC) in London.
Once European regulators clear such a deal, it's unlikely they'll exert much control over the companies' future behavior, she said: "Once it's through I think there will be occasional little upsets where the regulators have to reprimand them on this or that," but on the whole the new entity will be left to market forces. "It's a bit like the Microsoft-Netscape browser court case: it's all well and good; they're being fined, but Microsoft has still got the market."
Similar concerns from a varied legion of interest groups, corporate competitors and federal regulators have held up approval in the US. Several consumer groups lined up against the merger, filing a 115 page petition asking the U.S. Federal Communications Commission (FCC) to scrap the deal. Testifying before congress in July, media and cable services companies, including Walt Disney and BellSouth, said AOL and Time Warner together would discriminate against other media competitors trying to reach consumers -- be it with cable-television programming, interactive TV or broadband Internet -- via the merged company's cable services. Disney's complaints came shortly after a highly publicised dispute led to Time Warner dropping ABC and other Disney-owned stations from its cable offerings for two days during ratings sweeps weeks.
Companies providing instant messaging services like Yahoo and Microsoft have also opposed the merger. The companies claim that AOL is stalling movement toward an interoperable standard between competing software and AOL Instant Messenger, considered the most popular service. AOL has said that questions of privacy and security have kept it from settling on an open standard. The US Federal Trade Commission has pressed for a resolution to the instant messaging issue and has expressed concern over a potential cable monopoly growing from the merger, but has not formally moved to block the deal.
Regulators have also been concerned about AT&T's 25.5 per cent stake in Time Warner Entertainment, acquired with AT&T's purchase of MediaOne Group. In the latest of several letters sent to the FCC, counsel for AOL and Time Warner argued that AT&T's limited partnership stake is non-voting and non-controlling, that it "carries with it no management rights and no meaningful role." The FCC made the letter public Tuesday.
With additional reporting by Rick Perera in Berlin and George A. Chidi Jr. in Boston.
IDC is a subsidiary of International Data Group, the parent company of PC World.