The Internet has been the application platform of choice for about six years now, and this is not going to revert back to the desktop just because Billg would like it to. Funnily enough, the open source folks are only just starting to twig this change themselves -- there was some recent post I am too lazy to find wondering if a service that runs on open source software carries any open source obligations a locally executing application would (answer: no) how how licensing might be altered to change this.
Microsoft's discomfort with this brave new world becomes clear when you consider they think they are in competition with Google because it means you are consuming processing cycles remotely, not locally. When you think about it, this is kind of true, but their response (compete with google using MSN, not make NT the real server-side Unix killer it was meant to be and, oh yeah, make it free) shows you how poorly they fit in the networked world.
Longhorn attempts to redress that by integrating the Windows client with the (not yet, but soon to be) Windows server, all running on WinFX APIs, the networked equivalent on the infamous Win32 APIs. On top of this, data becomes integrated by residing not in files, but in a database that itself is part of the OS. This is a good move in general, but I'm guessing this will mean bad things for file compatibility across systems, something that is pretty easy in this age of plaintext, pdfs, and html documents. Finally, Microsoft is developing the post-browser browser, which will work best when talking to MSFT servers and will be distinct from IE (which will continue to languish as it does now). You can see bits of this coming together already in the new Office launch, which has built in collaboration features that Lotus Notes has had forever but no one could find (or, more tellingly, cared).
It all adds up to a big chicken and egg problem that I don't think even Microsoft can structure a solution to. I don't think Windows is going away any time soon, but all the action is no longer running on Win32 APIs, it's all on the internet operating system.