The transaction is valued at more than $4bn. As part of the deal Yahoo will pay $1bn to acquire stock from the private company and some of its shareholders.
Alibaba, based in Hong Kong, is an online marketplace where businesses can buy and sell anything from iron ore to electric toothbrushes.
The company owns the Taobao auction website and the AliPay online payment provider. The combined services realised over $4bn in transactions last year.
"We believe that the combination of Yahoo and Alibaba is the best approach for Yahoo to win in this region," said Yahoo chief executive Terry Semel.
"Our combined assets will make us the only company that has a leading position in all the key sectors driving explosive internet growth in China such as search, commerce and communications."
Yahoo is the number three search engine in China, handling 21 per cent of the nation's search queries. Baidu leads the pack with 37 per cent, followed by Google at 23 per cent.
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