In the mid-1980s, Deutsche Telecom began development of ISDN deployment in Europe. The conglomerate asked Dieter Seitzer, a professor at Germany's Erlangen University and head of the Fraunhofer Institute for Integrated Circuits, to research deploying high-quality, low-bit-rate audio coding over these digital lines. Seitzer appointed researcher Karlheinz Brandenburg, a specialist in mathematics and electronics who had been researching music compressing methods since 1977, to head the project, officially dubbed EUREKA Project EU147, Digital Audio Broadcasting (DAB).

By April 1989, Brandenburg's team, which included Bernhard Grill, Thomas Sporer, Bernd Kurten and Ernst Eberlein, had received a German patent on their new code, which was able to shrink a digital music file down to 12 times its original size without any appreciable sonic quality loss. Three years later, the algorithm was integrated into the new MPEG 1 specification and renamed MPEG 1 Audio Layer 3, shortened to MP3. In 1996, Fraunhofer was granted a U.S. patent.

The first software MP3 player, the AMP MP3 Playback Engine developed by Tomislav Uzelac of Advanced Multimedia Products, appeared in 1997. A year later, two university students, Justin Frankel and Dmitry Boldyrev, ported AMP to Windows and created Winamp for the Windows operating system. Winamp boosted the visibility of MP3 to mainstream PC users.

Following on the heels of MP3 came other music "codecs", short for COmpressor/DECompressor, such as Windows Media Audio (WMA), Advanced Audio Coding (AAC), Liquid Audio and MP3 Pro. Because MP3 was the first and most well-known format, its name was co-opted to denote all compressed digital music files.

MP3 files became portable in 1998 with the introduction of the Rio 300 from Diamond Multimedia, which used a small removable flash memory card to store compressed music files. But the digital music revolution really took off in October 2001, when Apple introduced its stylish iPod MP3 player series, which included a model with a 20-GB hard drive – enough to hold nearly 5,000 songs – in a player smaller than a deck of playing cards. Along with the iPod was Apple's iTunes online music store, which offered individual song downloads for 99 cents each or entire albums at $9.99. Most players today use either a removable flash memory card that can store as much as 500 songs, or a miniature hard drive that can store upward of 20,000 tracks.

A small record label, Sub Pop Records, was the first to post downloadable MP3 music files in February 1999. Later that year, an 18-year-old Northeastern University dropout named Shawn Fanning created a program that allowed consumers to trade MP3 files stored on their own local hard drives with other music files stored on other consumers' hard drives. This file-swapping program was called Napster, a nickname Fanning got because of the way he tucked his nappy hair under a baseball cap.

Distributed on the Web, Napster soon was attracting millions of users around the world and got Fanning on the cover of several national magazines, all to the consternation of the music industry. While consumers had traded audio cassette copies of albums or CDs for years, the volume was not high enough to impact sales. But record companies attributed dipping CD sales to the millions of tracks being traded on Napster and its ilk every hour, and believed that file swapping was theft of copyrighted material. File swappers and even a few artists believed that they were creating audiences for new music that might not have otherwise existed and making available recordings unavailable on CD.

In December 1999, the Recording Industry Association of America (RIAA) sued Napster for copyright infringement. In February 2001, Napster was forced to discontinue distribution of copyrighted files and six months later shut down. But in the meantime dozens of other so-called Peer-to-Peer (P2P) music file sharing sites had popped up such as Grokster, Kazaa and Gnutella. The RIAA then went after the music swappers themselves. In April 2003, the RIAA successfully sued college students running campus file swapping programs, and in September 2003, it brought the first of a wave of suits against 261 alleged file swappers.

The campaign of the record industry to stamp out music file sharing has not dampened consumer enthusiasm for small portable MP3 players, which allows music lovers to carry practically their entire music collection around with them. MP3 players with even more copious 40-GB drives began appearing in 2003, along with a growing number of legal online music services owned by equipment makers, record labels and software programmers that soon could cause the disappearance of the local record store. Even Napster resurfaced with a more traditional – and legal – music download site in 2004, which featured a new subscription-based model in addition to traditional pay-per-download service.

To battle the emerging digital download market and to make CDs a more desirable alternative, several major record labels launched the Dual Disc format, essentially a CD and DVD combined. The CD side included both the standard digital version of the record along with pre-ripped and copy-protected compressed tracks, while the DVD side contained music videos and other bonus features. Used in a computer DVD drive, a consumer also gained access to the artist's website and updated information.

Several companies also have begun introducing so-called home audio servers, components equipped with a CD and/or DVD player and a large hard disk drive designed to store thousands of compressed digital music files. These home audio servers are designed not only to store entire collections of music, but to distribute the music through home networks, both wired and wireless, to multiple locations around a home and, via the Internet, to other locations.