The European Commission wants to force a significant change in the way Microsoft sells its products, a lawyer for the software firm has claimed.
The legal arguments are over European competition issues
Microsoft is in Luxembourg for an anti-trust hearing as it tries to overturn a 2004 Commission ruling that it broke competition law.
Brussels fined the US giant 497m euros ($613m; £344m) in 2004 and told it to open up its software to its rivals.
Microsoft argues the EU's ruling would stifle innovation.
"What the Commission is seeking here is a dramatic change in Microsoft's business model," said Microsoft lawyer Jean-Francois Bellis.
Lawyers for the Commission said that unless Microsoft gave its rivals greater access to its programming code and stopped selling its Media Player as part of its Windows package, then rivals may be forced out of business.
Per Hellstrom, a lawyer for the Commission said that Microsoft's size and near monopoly position meant that the case had "vital importance for innovation".
"Microsoft cannot be allowed to decide who can innovate and who cannot," he said.
The companies appeal is being heard over five days by the 13 judges of the European Union's Court of First Instance.
On Tuesday the panel of judges asked questions based on the testimony of the two sides given on Monday.
Microsoft says it acted legally and the judgement should be overturned.
Judge John Cooke, who will write the court's draft judgment, examined Microsoft's defence that consumers benefited from an improved Windows operating system.
He also questioned if Microsoft's bundling of its media player with its Windows system, a move the Commission has ruled as illegal, really worried consumers and computer makers.
The Irish judge also said one of the key issues the court was looking into was whether the bundling was a "market strategy to gain market share".
A decision in the case is not expected for months, possibly a year.
If Microsoft were to win the appeal it would mark a drastic blow for competition regulations at the European Commission.
Microsoft claims the Commission's decision to force it to offer a version of Windows without any media player system - known as XPN - had failed.
On Monday lawyers for the software giant told the court that XPN sales represented 0.005% of overall XP sales in Europe.
The Commission's lawyer admitted that its attempt to force Microsoft to unbundle its media player had not been hugely effective.
"I am afraid we cannot say our remedy has had any real impact, as far as we can see," Mr Hellstrom said.
According to Microsoft lawyer Jean-Francois Bellis, the company's Word software has a 92% market share even though it has never been tied in to Windows.