Recently Microsoft announced it's partnership with Activated Content and the creation of a platform for free, ad-supported music downloads. In its most simple form a meta tag which contains the buyer's or the retailer's information is added in purchased tracks. If any of them leaks to Peer-2-Peer networks the buyer can be identified and ... told he has been a very bad boy.  This simple form is used in iTunes Premium MP3 tracks where the full buyer's name is written in cleartext inside the track. But this info can be easily removed. 

It gets more interesting when cryptography, digital signatures, spread spectrum and other exotic technologies are used. The information now is embedded in many places (spread spectrum), all over the media file, in an invisible way. Ideally humans cannot understand the difference between the watermarked and non-watermaked media content; no one except the provider can read the hidden information and it cannot be removed without destroying the media file (e.g. conversion to other format or lower quality won't remove it). So when a track is found in a P2P network, depending in the embedded information, the provider can trace the online store it was sold from or even the name of the buyer!

 

The photo above describes the system:The buyer purchases a media item, it is retrieved from the place in the disk where it is stored, processed on-the-fly to add the watermark and sent to the buyer. A specially designed software or hardware client can then identify the the embedded watermark and read the available information in it. 

As I said this technology won't be used in the 1 million Zune Marketplace MP3 tracks. 

External Links:
Microsoft's Partnership with Activated Content
Microsoft patents DRM-free watermarked music
Activated Content website

Digital Watermarking (Wikipedia)  

[via ZuneInsider ]