I think this is a “damned if, damned if not” situation. If they don't do anything, Microsoft will release Longhorn and Google, if the reports of seach integration are true, is doomed.
On the other hand, if they do this at least they might snag a few million users before Longhorn is released, some of which will switch back when they upgrade. They'll be left with a few people who go on using their thingy and ignore Longhorn's stuff. No new people will try Google's thing because Longhorn already does what they thing they want.
I think you're right. It's not so much that you have a choice about taking on Microsoft -- you can remain in the shadows for so long, but eventually, Microsoft tries to nullify your existence, not the other way around.