Under the terms of the agreement, Microsoft will develop a new software layer and SanDisk will develop the hardware that will put Windows software applications with their associated preferences and settings on a U3 smart drive.
The offering will allow secure access to personalised email programs, web browsers, productivity tools, multimedia applications and more, Microsoft said.
This computing environment will be accessible on Windows XP and Vista computers with a USB port or Flash card reader.
The new offering is expected to be commercially available from the second half of 2008 and will replace SanDisk's existing U3T Smart Technology.
Microsoft is already in discussions with third-party hardware vendors interested in licensing the new software offering.
A new entity will be created to license compatible hardware designs, TrustedFlash and other intellectual property from Microsoft and SanDisk, with revenues to be shared by the two companies.
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