As part of the deal, Yahoo has also agreed to contribute its China business, Yahoo! China, to Alibaba, according to a joint statement from the two companies. The agreement makes Yahoo the largest strategic investor in Alibaba.
The combined entity would also include 3721.com, a Chinese language search engine that Yahoo acquired last year, it said.
Yahoo will have 35% of voting rights in Alibaba as a result of the investment, said the statement, which was distributed at a press conference in Beijing.
The deal is the biggest yet in a flurry of investments in China by foreign internet companies eager for a share of a market with more than 100 million people online.
The alliance between Yahoo and Alibaba represents a challenge to US-based eBay, the world's biggest online commerce company, which in 2003 bought a Chinese portal, eachnet.com.
China has the largest number of
internet users after the US
Alibaba was founded in 1999 by Jack Ma, who has become one of China's most promiment internet entrepreneurs. The company is based in the eastern Chinese city of Hangzhou, southwest of Shanghai.
Alibaba runs both Chinese- and English-language auction sites serving foreign companies looking for Chinese wholesale suppliers and individual Chinese buyers and sellers.
News of the deal comes just days after an initial stock offering in the United States by another Chinese online firm, search engine Baidu.com, set off a frenzy of buying.
Its shares soared more than 350% in their first day of trading on Friday before declining slightly this week.
The Chinese government said last month that the number of people online in China had reached 103 million - the second-biggest population of web users after the United States.
But Chinese online commerce is still in its infancy and consumer spending is low in a society where urban incomes average just US$1000.