Nokia is good at reinventing itself. The world’s largest mobile phone maker has at various times in its past run paper mills, generated electricity, manufactured rubber boots, tyres and gas masks and, more recently, consumer electronics such as TVs. The focus on phones is a recent development for a company that started out in Victorian times and was a diversified industrial conglomerate until the 1990s.

Nokia’s decision to concentrate on mobile phones, however, could yet prove its undoing. The company has seen its worldwide market share fall back – from 35% in the fourth quarter of 2009 to 31% in 2010 – in the face of growing competition. The big problem is that Samsung, HTC and especially Apple are winning over customers in the lucrative smartphone market. Apple’s iOS and Google’s Android are providing stiff competition to Nokia’s aging Symbian software and manufacturers from emerging markets, in particular China, are eating away at its low-end sales.

Nokia may have posted a turnover of €42bn in 2010, but within the company there was a growing sense of being under siege. Innovative new handsets such as the photographer-friendly N8, or the Linux-based N900, failed to win over consumers. Nokia’s E Series business phones failed to gain ground against Research in Motion’s BlackBerry, and the general public wanted an iPhone, or at least something that looked like one.

By the middle of 2009, as stock markets started to recover, the best Nokia’s shares could do was hold their own. By last spring, its shares were in decline. Then in February this year they dipped again, losing close to a quarter of their value (based on Nokia’s New York share price) in four days’ trading. Clearly the world’s largest phone maker was in trouble.

The dramatic fall in the share price followed an equally dramatic memo by the company’s CEO, Stephen Elop. The Canadian former Microsoft executive, and the first non-Finn to lead Nokia, likened the choices faced by the manufacturer to a man caught on a burning oil rig, faced with certain death or an uncertain dive into the North Sea.

In the leaked memo – confirmed as real by Nokia – Elop told staff that the company was “standing on a burning platform” and that Nokia had even “poured gasoline” on it. The cause of the flames: Apple’s iPhone. “The first iPhone shipped in 2007 and we still don’t have a product that is close to their experience. Android came on the scene just over two years ago, and this week they took our leadership position in smartphone volumes. Unbelievable,” Elop wrote.

A few days later, at a press event in London, he confirmed what many observers had started to suspect. Nokia was forming an alliance with Microsoft.

After 15 years in which Nokia had been viewed as a bastion against Microsoft, the Finnish company was ditching Symbian and abandoning work on MeeGo, a Linux- based system for high-end phones it was developing with chip-maker Intel. Instead, it would install Windows Phone 7 in its higher-end handsets.

The consequences go beyond simply a change of direction for Nokia, and a feeling for individuals and companies that have invested in Symbian phones that they have backed the wrong horse. Finland’s minister for economic affairs expects Nokia to make some 20,000 staff redundant as a result of ending its development of smartphone software.

Brokers marked down Nokia’s shares, with UBS setting a price target of €7.30 – down from €8 – and revising its estimates for Nokia’s smartphone shipments by 7%. In a research note, UBS analyst Gareth Jenkins described Nokia’s move as a “seismic shift in the handset industry” but added that the main beneficiary stands to be Microsoft.

“Nokia is eliminating any incentive for consumers and developers to buy into its existing smartphone products, which are based on its Symbian and MeeGo operating systems,” said William Kidd, at analysts IHS iSuppli, following the announcement. “This will have a further negative impact on Nokia’s already eroding position in smartphones.”

Nokia’s loss, though, could be Microsoft’s gain. Microsoft should profit from enlisting the support of the world’s largest phone maker for its Windows Phone 7 software, which has largely been well received by reviewers but has yet to capture the imagination of consumers. Microsoft will also be hoping that Nokia can bring some of its engineering prowess and design flair to its platform. The fact that many of the existing companies making Windows phones also make handsets running on Android, and that the phones themselves look rather similar, has created something of a “me too” feel about Windows Phone 7.

Nokia will not be making Android phones, so the new handsets should, at the very least, bring something more distinctive, and perhaps distinctively European, to the market. “Had this not happened, a year from now both companies risked being quite moribund in the [smartphone] space,” says Tony Cripps, principal analyst at Ovum, the industry research firm. “It was a necessary step.”

It might yet be too early to write off Nokia. The company has, after all, managed more significant transitions than simply changing the software in its phones. And although the deal with Microsoft has been widely criticised – with brokers and analysts expressing a preference for Nokia adopting Android instead – no one has actually seen a Windows- powered Nokia phone yet.

If Nokia can confound its critics and produce a truly good smartphone, the company could still do well – although it might only have one chance to do so.

The biggest challenge for Nokia at the moment is the time it takes to produce the new phones. Originally, they were expected this autumn; now some Nokia executives have suggested a spring 2012 release. If that were the case, then rivals – including Android, Apple’s rumoured iPhone 5 and new phones based on Palm’s WebOS, now owned by Hewlett- Packard – could further squeeze Nokia’s market share. But the risks of going to market with a poor-quality handset could be greater still.

“Nokia made some of the best handsets, but something in their execution [of strategy] left them adrift and others were able to come into the market,” says Frazer Bennett, a partner in the technology group at PA Consulting. How well Nokia executes its move to Windows will determine whether the company succeeds or fails, he says. “The challenge Nokia faces is to continue to differentiate its products. It has released control of the user experience to Microsoft; that task will be harder than it was.”

As companies that have partnered with Microsoft in the computer business will testify, it is hard to avoid becoming a commodity maker of hardware, such is the strength of Microsoft’s brand and its operating system. Companies that have retained their identity while running Windows have largely done so by focusing on features that most PC makers ignore, as Sony has done with its media-oriented Vaio laptops and PCs. Others, such as HP, have tried to bury Windows under touch interfaces. A Nokia Windows Phone 7 handset is more likely to succeed if it takes the former approach, and plays to Nokia’s strengths in manufacturing and design.

But Nokia could benefit in other ways from the tie-up. February’s announcement was not the first time the two companies had collaborated; they signed a wide- ranging technology agreement as far back as 2005 and, more recently, Nokia agreed to support Microsoft technologies in its business phones. It could even be that Nokia and Microsoft find their real niche in business phones, taking on not Apple or even Google but Research in Motion, with its BlackBerry, and HP and WebOS. According to PA Consulting’s Bennett, Microsoft is increasingly focused on delivering services to businesses through cloud computing.

If Nokia can make devices that work with Microsoft’s business offerings in the cloud, it could open up a market that the European manufacturer had barely touched on with its Symbian- based phones. But even if Nokia does make a successful Windows phone, at one level at least, Europe has lost a technology powerhouse. The knock-on effect on companies in Europe, involved in developing software, electronics and even industrial designs for mobile phones, could be far-reaching. Increasingly, the direction of Nokia’s future designs will come from Microsoft’s Redmond headquarters and from the cluster of hi-tech companies in Silicon Valley. And Nokia is by no means Microsoft’s only licensee for Windows Phone 7.

“Anyone who wants to get under the skin of the Windows Phone platform doesn’t need to talk to Nokia. There are other licensees,” says Mike Butcher, European editor of technology blog TechCrunch. “The strategic thinking will shift to the West Coast of the US, so European technology firms will have to take the redeye to Silicon Valley.”

There is also a question mark over the future of Nokia’s innovation labs in Berlin, which had been heavily involved in developing Nokia’s Ovi apps store and mapping technology, suggests Butcher. The company’s industrial design centre, based in London, looks safer.

As Butcher points out, the drift to the US – and also to the East – is not new in the mobile industry. Support for Symbian among application developers has been declining for some time, with talented young coders, and investors, focusing their efforts on Android and Apple’s iOS. “We came out [of Nokia’s announcement of the deal] saying Symbian was dead, although Nokia executives tried to put a brave face on it,” Butcher recalls.

Finland, though, will continue to be a science and engineering hub, whatever happens. It has the world’s third-highest graduation rate, and other Nordic companies such as Skype have publicly invited ex-Nokia staff to join them.

Just as few workers in the forestry-supply industry of the 1960s and 70s could have predicted the growth of the mobile phone, so no-one can be sure where the next wave of innovation will come from. But it would be unwise to bet against it coming from Nokia, or from the scientists, engineers and designers who learned their trade there.