It seems Google will allow them to build an HTML5 app, even though Microsoft has repeatedly breached their TOS multiple times (like allowing users to download the videos). If Microsoft's WP8 platform is so behind the times, it can't even make an HTML5 web-app possible, that's really Microsoft's problem. If I'm not mistaken all the other "native" Youtube apps on other platforms are Google's own apps, and it's also the…
Prerogative or not, it's still douchey of Google to outright block Microsoft. The original Apple version of YouTube only shows videos that do not want advertising (granted a smaller and smaller # of videos).
The current fight started when Microsoft released an update that showed all YouTube videos, without ads, ignoring the advertising-requirement flag.