Let’s set the record straight: Windows may have heft. Facebook may have buzz. But there is still no bigger name in the pantheon of global software than Microsoft Office.

On the occasion of today’s consumer launch of Office 2010 (downloads starting at $119 for Home and Student, up to $349 for Professional), it’s a convenient time to take stock of the franchise. Though it might seem like a simple package — Word for documents, Excel for spreadsheets, PowerPoint for presentations, Outlook for email, plus a few other goodies — it is vitally important to Microsoft (MSFT). The software giant’s Office-anchored business division accounts for a staggering third of its revenue and more than half of its income. That means it accounts for roughly $20 billion in annual sales.

But is Office in a slow decline?

Microsoft’s rivals hope so. Google (GOOG) has taken aim at the franchise with its online Google Docs software, which is free and runs in a browser. Adobe (ADBE) offers Buzzword and Tables. Apple (AAPL) offers iWork on Macs. For large companies, IBM (IBM) has Lotus Smartsuite, and Oracle (ORCL) offers Open Office. And then there are a slew of upstart rivals like Zoho and Thinkfree that aim to grab a piece of Office’s market share.

So far, though, they haven’t done much damage. As Forrester Research analyst JP Gownder points out, about 67% of U.S. online consumers regularly use Office at home, compared to just 4% who say they use Google Docs, its highest-profile rival. (And Google’s product is free.) Stephen Elop, president of Microsoft’s Business Division, has a deft way of putting his challengers in their place: “Our biggest competition,” he says when I meet him on a recent visit to Microsoft headquarters, “is the last version of Office.”

Since so many people already have an older version, the logic goes, Microsoft needs to offer a compelling reason to upgrade.

But this only tells part of the story. It’s probably more accurate to say Office’s biggest competition is the version consumers can get for free — whether that means the copy they already bought, the pirated copy from a cousin, or one of the online up-and-comers. That’s likely why Microsoft has, with Office 2010, released free editions of Word, Excel, and PowerPoint that work in web browsers in a suite called Office Web Apps.

It’s an effort that Elop threw his weight behind when he joined Microsoft two and a half years ago, after spending years as an executive in Silicon Valley. Not only did Microsoft need to offer a free online version, it had to be a great-looking product, he determined, not a watered-down compromise. “Part of my role was to say, this thing called the cloud is so important, we have to fully embrace it,” he says. “That’s a key element of my leadership strategy — to say our largest and best customers, we should be leading them to the cloud.”

Microsoft is by no means early to the free software party — Google Docs has been around for more than three years. But if they were truly going to move some of its most precious properties to the browser for free, executives had to find a way to do it without sacrificing the lucrative business behind it.

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As he strides out of a Microsoft conference room where he has just given a speech to a few guests, Steve Ballmer smirks at one of his handlers. “We won that one,” he says. “Seven to five.” He’s talking about the computing devices in the room. Seven of twelve are running Windows.

Moments like this tell you a couple of things about Microsoft’s CEO. One, he keeps score. Two, he’s obsessed with winning.

So it’s counter-intuitive that Ballmer would stand for giving away a free version of Office. Microsoft likes to charge for software. Giving it away for free looks like a great way to lose revenue and profit, the things that matter most to a CEO. Yet indeed, Ballmer was one of the key strategists who backed the Office Web Apps idea.

Why?

Ballmer is careful to point out that while consumers use Microsoft Office quite a bit, they don’t often buy it. “Today in the consumer market, in some sense you could say most of our units are pirated. Many used, but not many paid for,” he says. The free online version is part of a calculated upgrade strategy: by introducing consumers to that, and to free partial versions preloaded on PCs, Microsoft believes it can entice some to whip out their credit cards and upgrade to the full version.

Sure, maybe only a small percentage of consumers will pay — but that’s money Microsoft probably wouldn’t have gotten anyway. (Microsoft thinks most businesses aren’t likely to try using the free version exclusively; it lacks corporate features like e-mail management and high-end collaboration.)

There’s another benefit to the free consumer offering: With Office Web Apps, Microsoft is offering an entry point to its other web properties — most importantly, its Bing search engine. A few million online Office users who are newly exposed to Bing should help it to take some search share from Google. “It gives us a base where people will get to see the breadth of our offering,” Ballmer says coyly.

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Microsoft may be doing more than blowing smoke here. After using the online version of Word over the course of a few days, I can say it easily beats Google Docs; the formatting is cleaner, the fonts more attractive, and the controls more like the familiar desktop version of Word.

Appearances, however, are just a start. Over the next nine months or so, as Microsoft reports a couple of quarters’ worth of financial results, we’ll see if Office 2010 is having the desired effect: looping non-paying consumers into Microsoft’s free online world while enticing paying business customers to upgrade more frequently. If so, Microsoft will have dashed its rivals’ dreams of taking down the mighty Office — at least for now.