In 2006, when Google started to offer its search services in China, the company was criticized widely for "selling out" by agreeing to let the Government of China install filters on the system that allowed them to censor content.
Google was not a fan of the idea, but in the interest of establishing a foothold in the fastest growing Internet market in the world they held their nose and went in anyway - possibly under the delusion that bringing the world to China would help to make that country less restrictive of speech and personal freedoms. Kind of what the International Olympic Committee hoped would happen with the Beijing Olympics.
It's hard to pinpoint exactly where the relationship went sour, but it was probably around March 2009 when China blocked access to YouTube, which is owned by Google. A few months later Chinese officials accused Google of spreading obscene materials through the web, after which point various services like Google.com, Gmail and other Google online services were temporarily blacked out behind the Red Curtain.
Then, last October, a group of Chinese authors accused Google of violating copyrights with its digital library and threatened to sue.
Just over a week ago things came to a head after Google went public to say they had discovered an attack on company servers originating in China. While they did not accuse the Chinese government directly, others have put two and two together and traced the attacks back to a source that has links to the government. Google all but confirmed as much with their announced decision to no longer censor content within China.
As well, Google revealed that the same source had hacked the Gmail accounts of Chinese human rights activists. Google threatened to pull out of China altogether. It appears that they may actually make good on that threat, despite the fact that their Chinese operations are profitable and that they would be abandoning a market of more than 350 million Internet users in that country.
The U.S. State Department also got involved. Although Secretary of State Hillary Clinton didn't mention China by name she recently made a statement that "countries or individuals that engage in cyberattacks should face consequences and international condemnation."
China tried to defuse the situation by downplaying it, while also proclaiming loudly that they didn't care much either way what Google decided to do.
China invited Google to resolve the dispute by legal means within China, while Google said they would approach government with a plan that would eliminate all censorship - something they know won't fly under the current regime.