It may not look it, but that funny little black box that sits underneath millions of television sets has a surprisingly high capacity for extra intelligence. Initially designed as a way for pay TV operators to sell a package of extra TV channels, the set-top box has tended to sit rather passively alongside your VCR and, perhaps, a DVD player and games console.

Making the set-top box smarter should be good for the TV viewer. But if the box is to become the hub of home-based communications and services, who controls the box is shaping up to be a massive fight. Among the contenders are pay-TV operators including BSkyB and NTL, to software giant Microsoft to games console and TV-maker Sony.

"There is a bit of a set-top box war," says James Ackerman, CEO of Open TV, the leading provider of software technology for set-top boxes. "Primarily, it is around the future of the boxes. Today they are all thin client (terminals that filter pay-TV services), but boxes will become more like computers with hard disks and browsers and personal recording functions."

Today you can buy a digital TV set that also allows you to receive ITV Digital (the recently re-named ONdigital pay-TV service) or Sky Digital. But so far these so-called integrated TV sets don't offer both pay services. If you just want the few free digital services now available, a digital TV set will do, but so far this pitch hasn't been moving digital sets off the shelves. Of the nearly 5 million TV sets sold in the UK last year, less than 150,000 were the more expensive digital TV sets, says Sony UK.

Before the end of this summer, BSkyB, the largest purveyor of set-top boxes in the UK, is launching its second-generation Sky Plus set-top. Nokia plans to follow with its PC-like set-top box this November. The new souped-up Sky box, being built by Pace Microelectronics, will have a hard storage disc with a 40-gigabyte capacity, able to record about 20 hours of programming, as well as full VCR functions. Sky Plus will also right an old wrong: you will be able to record one programme while watching another one. But will this make the box a hit with consumers?

One big question is how to price these new, upscale boxes, especially since both Sky and ITV Digital have been giving away boxes to encourage subscriptions. Nokia's plan to sell its Media Terminal box in the UK for between £500 and £600 is being re-assessed; the Finnish firm is reportedly asking retailers to subsidise the cost. Having already attracted 5.4 million subscribers willing to pay extra for more TV, lots of movies and live sport, Sky wants new services to help it reach its next target of seven million subscribers by 2003. At an estimated £400 each, this new Sky Plus box will be a Rolls-Royce rather than a cheap way to sign up for pay-TV. Sky won't confirm a price yet, but Sky CEO Tony Ball says the company will continue to offer a free box to drive digital pay TV take-up. "Sky wants to wean its subscribers off the free model," says an executive from a rival pay-TV company. Sky says it is offering its subscribers more choice.

The consultants Durlacher Research says so-called personal video recording (PVR) capability will be standard on all set-tops in three years. Although the analyst Jay Marathe expects half of all TV homes to have a PVR-capable device by 2007, he admits the take-up will depend on price and perceived added value. The early signs could be called mixed: a standalone PVR box called TiVo went on sale in the UK last year for £399 plus a £10 a month subscription fee in a joint marketing effort with Sky. So far the US company, which declined to break down its UK sales, has sold only 200,000 boxes worldwide since its launch nearly two years ago in the US.

"Actually, we think these figures are pretty good for a new category," says Andrew Cresci, vice-president of TiVo in the UK. "In the first two years that VCRs were available, they sold only 120,000 worldwide."

The big question is how much intelligence and storage needs to be in the set-top box? The answer is it depends on the network you are connected to. "Video on demand is not scalable or an economical way to get EastEnders to 25 million households," says Jay Marathe of Durlacher. "PVRs where you can download programmes, combined with digital broadcast signals is the alternative that makes more sense especially when you see that the cost of hard-drive storage is coming down almost as fast as computer power is rising."

But not all people believe the box needs to have all the smarts. A start-up company called XTC, headed by former Channel 5 CEO David Elstein, plans a palm-sized box without storage capacity or expensive circuitry systems and an estimated retail price of £20 per box. Instead of having a hard disk, the XTC box creates a "virtual hard drive" that downloads the information it needs from a specific part of the broadcast signal. It is especially adapted for making analogue TVs capable of receiving digital TV signals. Mr Elstein believes this box could speed public acceptance of digital TV and make the Government's plan to turn off the analogue frequencies between 2006 and 2010 more feasible.

The UK cable TV companies say their sophisticated networks obviate the need for really smart (and expensive) set-top boxes. "Boxes are getting more intelligent, just like PCs," says Howard Watson, MD of networks and technology for Telewest. "But some networks need this high-end box more than others. My advantage is that we can use the two-way capacity of the cable network so I don't have to drive the functionality of the set-top box as Sky has to. The only way a satellite service has to look truly interactive is with PVR."

Cable company NTL is concentrating on finding compelling broadband applications to sell to its subscribers, rather than worrying about engineering its set-top boxes into high-capacity, digital VCRs. "Today's set-top box has functionality we've only just begun to exploit particularly in the high-speed modem," says Stephen Temple, NTL joint managing director of the technology division.

The focus on revenue-producing services and applications is fuelling competition among the providers of TV set-top box software and operating systems. This month, Open TV paid $59m (£41.8m) for content company Static, which includes the interactive games channel Playjam. Then last month, after several delays, Microsoft launched its set-top box software on its first pay-TV system.

Though the Microsoft system has had many technical problems, its rivals, Open TV, Liberate, News Data Systems and Canal Plus Technologies, recognise the competitive threat of the software giant.

The next generation of boxes will include connection points for other devices, from games consoles to PCs to personal digital assistants. These sophisticated "home gateways" could also connect to your home security system or your gas and water meters for remote monitoring. Soon these other applications will be able to connect wirelessly to the gateway device.

"I think it is a fantastic vision," says Mr Ackerman of Open TV. "But all of this is expensive and this is the quandary of the industry: how much will the consumer pay versus how much are the operators willing to subsidise these set-top boxes?"