The announcement came during Steve Ballmer's visit to LG's HQ in Seoul, Korea.
The collaboration is not a first for the companies. LG has already been making phones that run Windows Mobile. But the agreement could signal a stepped up effort by both companies to try to beat the competition.
While LG has had some hot sellers, such as the Chocolate, it now faces challenges from new competitors Apple and Google which are generating more excitement. Last week, Google introduced the first phone to run on its Android software, HTC's G1. Apple's iPhone continues to build momentum.
Microsoft too has been affected by the new competitors. It has been working recently to try to position Windows Mobile, traditionally regarded as solely a business tool, as also useful for more personal applications. LG has traditionally focused on phones that would appeal most to mass market consumers.
Both companies have slipped in rankings recently. A recent Gartner study showed that worldwide, Microsoft in the second quarter this year slipped into the third place among providers of smartphone operating systems, behind number one Symbian and number two ranked Research In Motion (RIM). Last year in the same quarter, Microsoft beat out RIM for the second position.
A recent IDC study showed that LG during the third quarter this year slipped into the number-five position worldwide among mobile phone makers.
In a statement, the companies said they expected that their agreement would create momentum and innovation in the industry.