Microsoft has also been showing a new media software, developing an application akin to Apple's iPod/iTunes integrated ecosystem, according to another source.
Record companies are expected to be receiving prototypes to test in the coming weeks, said the first source. The sources said Microsoft will be throwing significant marketing dollars behind the launch.
Both Apple's iPod player and iTunes Music Store are runaway leaders in their respective market sectors. The iPod has more than half of the digital media player market, according to research company NPD, while iTunes accounts for over 70 percent of digital music sales in the U.S.
Robbie Bach, appointed president of Microsoft's entertainment and devices division in December, is working with J. Allard, vice president of its Xbox team, on the unnamed digital media player/software project, according to a source close to Microsoft.
Allard's involvement is seen as significant because he is one of the few executives at Microsoft with experience in launching a consumer electronic device from scratch with the X-Box gaming system.
Analysts believe that for Microsoft to have any chance of competing with Apple in the next year, the software giant will need to have a player and service ready in time for the Christmas season, seen as crucial for the success of any consumer electronics launch.
Apple's simple approach to providing an integrated, seamless ecosystem for digital media is seen as the key to its success with iPod/iTunes.
Microsoft's ability to control both the hardware and software in such a project gives the company an edge. Japanese Sony had a similar approach. They owned content, devices, software and an online store. However, it hasn't enjoyed nearly the success Apple has.