Mikhail Khodorkovsky knew exactly what he was up against. Visiting Washington in early October, Russia’s richest man told a packed meeting at the Carnegie Endowment for International Peace how he, his business associates and Yukos — the huge oil company he runs — were being harassed by “the unlawful acts of law-enforcement agencies.” Prosecutors were hunting for evidence, raiding homes, offices and even his daughter’s school without court orders, he said, while hearings for two arrested colleagues were being held with complete disregard for due process. “All of this is against U.S. law, but it’s also against Russian law,” Khodorkovsky said.

The big question, he concluded, is this: “Are we going to become a democratic Russia for the first time in our thousand-year history, or are we going to continue along our thousand-year-old path of authoritarianism?”

A reply may have come early on the morning of Oct. 25. That’s when Khodorkovsky, 40, was arrested by armed Russian state security officials, who stormed his plane while it was refueling in the Siberian city of Novosibirsk. Five days later, last Thursday, Russian prosecutors froze 44% of Yukos stock — worth some $13 billion. The world’s fourth-largest oil company (and the source of much of Khodorkovsky’s wealth, estimated last year at $8 billion) seemed in danger of being forcibly renationalized. After the arrest, the Moscow stock market, resurgent all year, tumbled 11% in one of its biggest one-day declines since the debt crisis of 1998. President Vladimir Putin — the man widely assumed to be behind the arrest — called for calm, backed the prosecution, and refused to meet with Russia’s outraged billionaire oligarchs. The crisis even split Putin’s inner circle: his Chief of Staff, Alexander Voloshin, resigned in fury over not being consulted on the arrest, and Prime Minister Mikhail Kasyanov defied Putin’s order to stay out of the affair, saying he was “deeply concerned” about the freezing of Yukos shares.

Putin argues that nobody, however rich, is above the law. Khodorkovsky faces seven charges (see box), including embezzlement, theft and tax evasion, many of them dating back to the 1994 privatization of a fertilizer plant. He denies any wrongdoing; his many defenders say he’s being prosecuted for doing what most of the ruling élite did in the 1990s — taking advantage of the bargain-basement sale of state assets. The real reason for his arrest, they say, is political. He’s at the center of a titanic power struggle between “the Siloviki” (or hard men), as Putin’s coterie of security officials and bureaucrats is known, and “the Family,” the oligarchs and top officials who came to wealth and prominence during the wild days of privatization under former President Boris Yeltsin.

When Putin was elected President in 2000, those rival factions struck a deal: the businessmen in the Family, whose political wing included Voloshin and Kasyanov, were safe as long as they stayed out of politics. But when Khodorkovsky emerged as a force in his own right, he openly funded opposition parties and hinted at his own presidential ambitions. The Siloviki struck back by throwing him in jail, a move that some believe could herald the start of a much wider effort to turn back the clock on a decade of halting post-Soviet political and economic reforms. “Voloshin’s resignation means that we now live in a different state,” says Andrei Piontkovsky, director of the Center for Strategic Studies, an independent Moscow think tank. “This was the landmark between the end of the first Putin republic and the emergence of a second one, in which parliamentary and presidential elections are nothing but virtual reality.”

That thesis will be tested soon: a parliamentary election is set for December and the presidential vote for March of next year. Khodorkovsky began giving financial support to the liberal Yabloko and Union of Right Forces parties early this year. He also publicly played up his intention to leave business when he’s 45, just in time to prepare a campaign for the 2008 presidential election. Even the tour of Siberia he was making when he was arrested was seen as a way of drumming up support from Russia’s regional élites. “Khodorkovsky was clearly looking to build major power in the Duma [the lower house of the Russian parliament] and run for the presidency,” says Herman Pirchner, president of the American Foreign Policy Council.

By imprisoning Khodorkovsky, Putin hopes to neutralize him and silence the other oligarchs — but it’s a risky move. He wants to wreck his rival but not the Russian economy. Yet the arrest could actually bolster Khodorkovsky’s position, elevating him to the role of political martyr and giving the fractious opposition a figure around which to rally. “If we see that the President goes along only with the Siloviki,” says Boris Nadezhdin, deputy chair of the Union of Right Forces faction in the Duma, “we must topple such a President or else leave the country.” Determination like that, if it lasts, would put Putin in a bind. Khodorkovsky “is no timid rabbit,” says Boris Berezovsky, an oligarch who left Russia in 2000 when investigations were launched into his business practices. “He has made Putin fear him. From now on, Putin will fear him even more.”

The U.S. and German governments have also raised concerns about the Khodorkovsky case, asking for assurances that the arrest was legal. “It looks more and more like this is a very selective prosecution, for political reasons,” says a senior U.S. State Department official. “These things get expressed. They get raised with the Russians.” The Kremlin took offense at this, saying through the Foreign Ministry that such protests are “tactless and disrespectful.”

Putin himself took pains to downplay the significance of the arrest. “I would ask that all speculation and hysteria about this be stopped,” he said in a televised address. Three days later, he met in an opulent conference room at the Kremlin with a group of international bankers, including representatives of Deutsche Bank, Morgan Stanley and Goldman Sachs. He assured them that he wasn’t nationalizing the company, but simply freezing its assets so they would be available to settle the criminal claim. He said the moves against Khodorkovsky don’t herald any shift in the Kremlin’s pro-business policies. Indeed, he said he hadn’t known about the Yukos stock seizure in advance, and was 10 minutes late for the meeting because the prosecutor general’s office had just briefed him on it. But the businessmen weren’t assuaged, and many Russians are skeptical. “Nothing of this kind can happen at the Kremlin without the President’s knowledge, order or acquiescence,” says Lilia Shevtsova, a political analyst with the Carnegie Moscow Center.

“Khodorkovsky is no timid rabbit. He has made Putin fear him. From now on, Putin will fear him even more”

— BORIS BEREZOVSKY, Russian businessman

Khodorkovsky’s arrest could take a toll on growing international confidence in the Russian economy. The ratings agency Moody’s recently upgraded Russia’s sovereign credit rating in a move that seemed likely to encourage greater foreign investment. But any further signs that Russia is backsliding could have a chilling effect on foreigners and accelerate capital flight out of the country. Indeed, in the four months since Yukos has been in the firing line, an estimated $7.7 billion left Russia, a shocking reversal from the net $3.7 billion that entered the country in the second quarter. Yevgeny Yasin, an Economics Minister under Yeltsin in the 1990s, estimates that the flight will now accelerate.

For the moment, big foreign players continue to give Putin the benefit of the doubt. “Nothing that has happened over the past few days will change our attitude,” said Lord Browne, the chief executive of British oil giant BP, which recently finalized a $6.8 billion Russian venture. “We haven’t changed our long-term perspective,” concurs Peter Elam Håkansson, who manages a $250 million Russian stock fund out of Stockholm for East Capital. The fund is up about 100% this year to date, and Håkansson was using the market declines last week to buy up more stocks. “We know we have to handle risk,” he says, but “it’s still one of the most exciting places to invest your money.”

Russia’s super-rich oligarchs have been frequent political targets over the past decade; attacking them can be a vote winner because many Russians are deeply suspicious of the loans-for-shares scheme under which Russian industries were privatized — and through which these businessmen got their wealth. Two big players during the ’90s — Boris Berezovsky and Vladimir Gusinsky — have fled into exile. More recently, Roman Abramovich, a Siberian provincial governor, sold his oil company Sibneft to Yukos and bought Chelsea Football Club. (So far, Putin’s remarkable popularity is holding up: in a VTsIOM-A poll conducted last week, the President had a 73% approval rating.)

But Khodorkovsky is a different kind of oligarch. For one thing, he has become something of a socially-minded philanthropist. Yukos spends about $100 million per year on projects that include training thousands of high school teachers to use the Internet in the classroom and sending Russian teenagers to U.S. schools for a year. It also enjoys a reputation among foreign investors as perhaps the most transparent and westernized company in Russia. It has a cluster of Americans on its board and among top management, uses U.S. accounting standards and was the first major Russian company to detail its precise ownership structure. Most recently, it has been engaged in talks with both ExxonMobil and ChevronTexaco about the possible sale of as much as 40% of its equity, according to people familiar with the talks. While such a move would have amounted to a resounding vote of confidence in Russia’s economic future, it also might have put Khodorkovsky and Yukos out of Putin’s reach. The talks are now on hold. But the idea was characteristic of Khodorkovsky. “He’s the ideal opportunist,” says Anders Aslund, director of the Carnegie Endowment’s Russian program, who has known him for six years. “He’s at the top of any game there is.”

Khodorkovsky was born in Moscow in 1963 to a-lower-middle-class Jewish family. A straight-A high school student, he earned college degrees from two of Moscow’s most prestigious schools by the age of 25 and then got into politics. When Mikhail Gorbachev, who was then the Soviet President, started introducing political and economic reforms in 1986, Khodorkovsky was deputy chief of a Young Communist League (Komsomol) district committee in Moscow. It was a giddy new world of cooperatives and other legal private business opportunities and, like many Komsomol leaders, Khodorkovsky used the organization’s vast real-estate holdings and political connections. “He dealt in everything: blue jeans, brandy and computers — whatever could make money,” says a senior Yukos executive.

Not all his initial business forays turned out well, and from time to time he used his skills as a trained carpenter to supplement his income. But it was back then that he built the team that later was to emerge as Yukos top management — Platon Lebedev, Leonid Nevzlin, Mikhail Brudo and Vladimir Dubov. Soon they ran a network of enterprises reaching as far away as Siberia. The breakthrough came in 1988, when Khodorkovsky launched a commercial bank called Menatep. To help get it started, Gorbachev’s administration gave it the right to handle Chernobyl victims’ relief funds.

After the collapse of the Soviet Union, some accused Menatep of laundering Communist Party money, but the allegations were never proved. As his empire grew, Khodorkovsky acquired riches but shunned the flashy lifestyle, preferring modest clothes and cheap plastic watches. Even now, he prefers turtlenecks and leather jackets to designer suits.

He made his first million dollars in the early 1990s, when Menatep used its connections to buy large amounts of shares in companies that were being privatized. After a brief stint in the federal government, taking on the job of Deputy Fuel and Energy Minister between 1993-1994, he staged his biggest coup, acquiring Yukos at a state auction for $350 million in 1995.

Critics today accuse Khodorkovsky of grabbing valuable assets for peanuts. While it’s true he paid relatively little for Yukos, the company was flat on its back, owing about $3 billion in taxes and unpaid salaries to employees. It was also torn by labor strife. Yukos executives says it took two years of crisis management before the firm got back into shape — only to be sent reeling in 1998 by falling oil prices and Russia’s economic crisis. To make matters worse, Khodorkovsky suddenly found himself with a big fight on his hands when foreign shareholders, led by Kenneth Dart, the heir to an American foam-cup fortune, mounted numerous legal challenges to the way he gained control of the operations and cash flow of Yukos subsidiaries, allegedly to the detriment of minority holders.

Yukos insiders say that battle sparked a big change in Khodorkovsky. From then on, he embraced corporate transparency and began advocating Western-style govern- ance and values, casting himself as Russia’s Mr. Clean. “He is the first to admit that he and the others exploited the legal vacuum that existed in the early ’90s,” says a retired U.S. diplomat who knows Khodorkovsky personally. “But he was also the first to start speaking out for transparency in business and the need for active corporate citizenship in a democracy, and the first to put his money where his mouth is.”

Putin does not appear to have had any such epiphany about business. Indeed, he’s proved himself less committed to modernizing Russia’s economy than to consolidating his own power. His first priority is keeping the Russian state — and his own position — strong. While Khodorkovsky was cutting his teeth in commerce in the 1980s, Putin was a KGB major stationed in East Germany. He quit the intelligence service in the early 1990s and moved back to his hometown of St. Petersburg, where he began a political career that in 1996 brought him to Moscow and ultimately to the presidency.

Khodorkovsky’s current troubles began on Feb. 19. That day, he attended a meeting with Putin and top Russian business executives — and made a very sharp denunciation of official corruption, which he said was costing Russia $30 billion per year. Putin became furious, say Yukos insiders — and accused Khodorkovsky of hypocrisy, given his own dubious past and his decision to begin pumping money into the coffers of anti-Kremlin parties. The repercussions came quickly. Alexei Pichugin, Yukos’ senior security executive, was charged in June with a murder. A month later, Khodorkovsky’s partner Lebedev was arrested and charged with tax evasion. Soon after, Nevzlin fled Russia after being targeted for investigation. In October it was the turn of Vasily Shakhnovsky, head of the Yukos Moscow subsidiary. He too was charged with tax evasion.

After Lebedev’s arrest, Khodorkovsky and Yukos top management started doing some serious contingency planning. “He said there was a good chance he would be next,” recalls one company director. The company was confident of its accounts; it has been audited for the past four years by PricewaterhouseCoopers. And it put in place a succession plan that it is now executing. Taking over as chief executive is Steven Theede, 51, an American who used to work for ConocoPhillips and who crossed swords with Yukos before being recruited by Khodorkovsky to join it. Company documents show that Khodorkovsky had already arranged for the voting rights of his shares to be shifted to someone else in the event he was unable to act as a beneficiary. The Financial Times reported that the unnamed person is outside Russia. The prosecutor’s office said on Friday that it had unfrozen 2% of the seized Yukos stock after discovering that the shares were held by individuals not related to its inquiry.

“Khodorkovsy was clearly looking to build a major power in the Duma and run for the presidency.”

— HERMAN PIRCHNER, American Foreign Policy Council

Khodorkovsky’s first line of defense is to attack the prosecutor’s methods. In Washington last month, he described how preliminary hearings for both Pichugin and Lebedev were held in closed session, with the defense lawyers forced to sign gag orders. Moreover, Lebedev’s lawyer’s offices were searched without a court order, in contravention of Russian law. “We are very worried that the evidence that is going to be presented in the cases will have been fabricated,” Khodorkovsky said. That’s an argument Yukos lawyers are now planning to take to a broader public. Three of them have already met with members of the U.S. Congress and the executive branch, and they are expected to take their case this week to European Union officials in Brussels and Rome, where Putin will be attending a summit with E.U. leaders. At the very least, says Aslund, “it’s dawning on everyone that if the biggest capitalist can be arrested on totally flimsy charges, there’s no rule of law.”

Is Khodorkovsky’s arrest simply a tactical move to confound a potent rival? Or does it signal a new chapter in an old and miserable book? To Anatoly Chubais, chief executive of the utility Unified Energy System, a leader of the Union of Right Forces and architect of Russia’s economic reforms under President Yeltsin, the message is clear. The seizure of Yukos stock is “a serious sign that the political course is changing. People are now asking: ‘Who’s next?'” The answer may be Chubais himself. Last Thursday, agents from the FSB, Russia’s security agency, searched the offices of Novosibirskenergo in Novosibirsk, a Siberian subsidiary of Chubais’s Unified Energy System firm, as part of an investigation into alleged fraud by company managers. The answer to the question Khodorkovsky posed in his speech at the Carnegie meeting last month — “democracy or authoritarianism?” — may not be long in coming.

With reporting by Massimo Calabresi and Eric Roston/Washington and Yuri Zarakhovich/Moscow