The two U.S.-listed firms have been bitter rivals, locking horns in courtroom battles over alleged copyright infringement and unfair competitive practices.
Both companies have this month reported a net loss for last year, pinched by rising costs for Internet bandwidth, content and mobile video services.
But bringing the two together is a good move for a highly competitive industry with many players fighting over more than 450 million Internet users, analysts said.
"This creates China's biggest video site, but it doesn't create a YouTube - they still have less than 50 percent market share," said Bill Bishop, an independent analyst based in Beijing.
Youku currently leads the fragmented Chinese online video market with a 21.8 percent share, ahead of Tudou's 13.7 percent, according to Internet research firm Analysys International.
"We know online video is way too competitive. There are 10 players, where there should be only one to two," said Michael Clendenin, managing director of Shanghai-based RedTech Advisors.
"After this merger there are still too many players in the industry," he said, noting others in the market such as Sohu.com Inc, Baidu Inc, and Tencent Holdings Ltd, which is trying to develop an online video platform.
"These are not small, insignificant players. So even though this is a step in the right direction in terms of consolidation, there's still a long way to go," Clendenin added.
Far from stifling competition, though, one rival even welcomed the move.
"From an industry perspective, Youku and Tudou's deal is conducive for the healthy development of the sector," iQiyi, Baidu's online video platform, said in an email to Reuters.
"The cost of purchasing copyrights in the market will be more effectively controlled with fewer ... online video companies. It will also reduce the competition for bandwidth and market talent."
TUDOU SHARES JUMP
Once the deal is completed, the combined entity will be named Youku Tudou Inc, and headed by Youku chairman and CEO Victor Koo. Tudou's CEO Gary Wang will join the new entity's board of directors.
As of Friday's close, Youku's market value of around $2.85 billion was six times that of Tudou. Under the terms of the deal, Youku stock and ADS holders will own around 71.5 percent of the new company, with the rest held by Tudou shareholders and ADS holders.
In pre-market trading on Monday, shares of Tudou, which is 9 percent owned by Sina Corp, more than doubled to $33.52 from Friday's $15.39 close. Partly reflecting the tough competition, Tudou shares, which debuted in August, had consistently traded below their IPO price of $29 each.
"It (the deal) is a sign of how difficult this market is and both companies have probably realized how hard the road ahead would be if they went the independent route," said Bishop. "It should help them get to profitability. Tudou's earnings were released last week and were horrible."
"I imagine this will help other companies in the sector that are trying to list, by reviving interest in the sector. It will also pull up other stocks such as Renren, which could now become takeover targets," he added.
The two firms have sparred publicly in recent months, with Youku filing a lawsuit against Tudou earlier this year seeking 4.8 million yuan ($762,000) in compensation, saying it incurred losses because of claims by its smaller rival that Youku had misused copyrighted material, the official Xinhua news agency reported in February.
The row began in December when the two firms traded accusations of stealing and reposting videos from each other's sites.
Goldman Sachs, Allen & Company LLC and China Renaissance Holdings Ltd are financial advisers for Youku, the two companies said in statement.
Morgan Stanley acted as lead financial adviser and Credit Suisse as co-financial adviser for Tudou on this deal, they said.
(Additional reporting by Arpita Mukherjee in Bangalore, Melanie Lee in Shanghai, Lee Chyen Yee, Jerry Huang, Lawrence White in Hong Kong; Editing by Jason Subler and Ian Geoghegan)
By Kazunori Takada