Under the agreement, New York based Spiralfrog will offer Universal's songs online in the US and Canada.
Spiralfrog will launch the service in December and make its money by carrying adverts on the site.
The inclusion of the biggest of the Big Four music labels will give SpiralFrog an edge with consumers.
The move has the potential to shake up the online music sector, dominated by Apple Computer's iTunes Music Store, whose marketing of 99 US cent song downloads has become a model used by rivals.
Analysts predict success
Analysts say that the move by Universal is shrewd as the music industry as heading towards a point where all music delivery will probably be some form of downloading or streaming.
"Offering young consumers an easy-to-use alternative to pirated music sites will be compelling," Spiralfrog Chief Executive Robin Kent said.
Mr Kent said that his research suggested that in return for free music, young people would be willing to endure adverts - as long as the brands and products were relevant to them.
Figures from the International Federation of Phonographic Industries (IFPI) estimate that for each legal download, 40 are done illegally.
Analysts say that the success of Myspace has underlined the power of the internet to make or break artists - as well as proving that advertising-based formats can work.
Phil Leigh, a senior analyst at the research firm Inside Digital Media said the market has the potential to generate revenues in the same manner as radio.
"The US radio industry generates 20 billion dollars a year in revenue and they give the product away for free," he said. "Record labels generate 12 billion dollars a year and they sell their product."
Spiralfrog is discussing possible deals with other big record firms, but questions still remain over how the artists featured on Spiralfrog will be paid.
Artists may be hesitant
"The internet is very much a viable media, but the trick is going to be getting it off the ground in the first place," said US-based music industry legal specialist Josh Lawler.
"Spiralfrog will have to find a way to pay artists from the advertising dollars they are generating.
"But they're not necessarily going to know how many advertising dollars there are and so some artists are going to be hesitant about it," he said.
According to the IFPI, 60 million MP3 players were sold in 2005, while 420 million single tracks were downloaded during the year - up 20 times on two years earlier.
Many of the models sold are also expected to be incompatible with Apple's online record store - such as Sony's Walkman.
At the same time, numerous companies are jumping on the downloads bandwagon.
Entertainment retailers HMV and Virgin already offer music downloads, while music television channel MTV has opened its own online shop, Urge.
Microsoft is preparing to launch a music store to go with its Zune player, made by Toshiba, which is popularly viewed in the industry as an "iPod killer".