UPDATED with Warner Bros response.

EXCLUSIVE: A federal judge has denied a Warner Bros motion to dismiss 20th Century Fox's legal battle over the rights to develop, produce and distribute a film based on the graphic novel Watchmen. This is huge Hollywood news because Warner Bros plans to release on March 2009 its highly anticipated big-screen version of the popular comic book written by Alan Moore and illustrated by Dave Gibbons. Fox was seeking to enjoin Warner Bros from going forward with the project, and U.S. District Court Judge Gary Allen Feess on Friday refused to dismiss the lawsuit filed by Fox on February 12th of this year. "In essence, the Judge appears to conclude that Fox retained distribution rights in Watchmen through the 1991 Largo quitclaim, and he concludes that, under the 1994 turnaround, producer Larry Gordon acquired an option to acquire Fox's remaining interest in Watchmen that was never exercised, thereby leaving Fox with its rights under the 1994 agreement," a 20th Century Fox source just told me. "While the Judge's opinion is preliminary and his views could change in the course of the litigation, his current take on the facts is consistent with our position." I'm told the court is still contemplating Fox's motion for an injunction. This is indeed a stunning development which could imperil Warner Bros' entire 2009 movie slate. Sources point out to me that Warner Bros had a similar problem with the Dukes Of Hazzard movie before Judge Feess and had to pay tens of millions of dollars to release the film.

UPDATE: *Warner Bros officially gave the usual "it is our company’s policy not to comment on pending litigation" statement, but added, "The Court’s ruling simply means that the parties will engage in discovery and proceed with the litigation. The judge did not opine at all on the merits, other than to conclude that Fox satisfied the pleading requirements. We respectfully disagree with Fox's position and do not believe they have any rights in and to this project." But, privately, Warner Bros execs are decrying to me what they say is Fox's "opportunistic claim," noting that "Fox sat on its so-called rights for years while other studios in town developed this property. In fact, Paramount greenlit the movie for production and Fox never said a word! Fox even had an opportunity to re-acquire the project at some point and it passed on it!"

2oth Century Fox made this statement: "Warner Brothers' production and anticipated release of The Watchmen motion picture violates Twentieth Century Fox's long-standing motion picture rights in The Watchmen property.  We will be asking the Court to enforce Fox's copyright interests in The Watchmen and enjoin the release of the Warner Brothers film and any related Watchmen media that violate our copyright interests in that property."*

Not only was footage of Watchmen screened at the recent Comic-Con in San Diego, but Warner Bros pulled out all the stops to publicize the movie, from premiering action figure toys to showcasing the Nite Owl ship used in the movie to presenting a panel about the pic with director Zach Snyder, illustrator Gibbons, and the principal cast. The comic series -- fans argue over whether it can be called a graphic novel, since it was originally serialized in 12 issues -- depicts a 1985 world in which the repercussions of superheroes changed the timeline. Masked vigilantes have been outlawed by a McCarthyesque act of government, Richard Nixon is still president, and America won the Vietnam war with the help of a superhuman named Dr. Manhattan (Billy Crudup in the movie). When a man named Edward Blake (Jeffrey Dean Morgan) is brutally murdered, the investigations of masked right-winger Rorschach (Jackie Earle Haley) reveal that Blake was once The Comedian, a government sanctioned mercenary. Rorschach believes that all masked vigilantes may be being targeted by an unknown conspiracy, but the whole thing turns out to be much bigger and deeper than that.

Studios have been trying to make Watchmen into a movie since the 1980s when it originally was published. Producer Joel Silver at one point tried to get Arnold Schwarzenegger to play Dr. Manhattan, and Ah-nuld was said to be willing to shave his head and be painted blue. Terry Gilliam was attached to direct at one point, from a script by 1989 Batman scribe Sam Hamm and production designer Anton Furst, but Gilliam ultimately decided that he thought the book was unfilmable. Meanwhile Watchmen writer Alan Moore has disassociated himself from the film and Hollywood completely. Snyder as offered the helming gig while he was in post on 300, and accepted. At Comic-Con, the director said his aim has been to be as faithful as possible to the original material. And even fans who've seen the early footage -- a new series of clips shown at Comic-Con and scored to Gregorian chants, which included such things as Rorschach's ever-morphing inkblot masks -- say Snyder had done that. "The base is pumped for this movie," my Comic-Con correspondent Luke Y Thompson wrote.

In the lawsuit, 20th Century Fox contends that it owns the distribution rights to any motion picture based on Watchmen and argues that it has held these rights for almost two decades based on agreements with producer Larry Gordon and his related business entities. Fox asserts claims against Warner Bros and its affiliates for copyright infringement and interference with Fox’s contract rights under a 1991 agreement with Gordon’s affiliate. Warner Bros moved to dismiss the copyright and interference with contract claims, arguing that it has obtained all rights to produce and distribute the movie from Gordon or one of his companies, and that its acquisition of these rights can be traced through documents. So Warner Bros asked the Court on the basis of those agreements to dismiss Fox’s claims. Warner Bros also asserts that Fox abandoned any interest it had in Watchmen in 1991 when it purportedly quitclaimed its distribution rights to Gordon according to what the court acknowledged was "a very complex, convoluted series of negotiations and agreements". (Welcome to Hollywood, folks...)

Here's the fascinating chronology that the court laid out:
1986-90: Fox acquires motion picture rights in The Watchmen.
1990: Fox enters into a domestic distribution agreement with Largo Entertainment, a joint venture of JVC Entertainment Inc., Golar (Larry Gordon), and BOH, Inc. The “Largo Agreement” established Fox’s domestic distribution rights, through a license from Largo, in “subject pictures” as defined in the agreement.
June 1991: Fox enters into a “Quitclaim Agreement” with Largo International, through which Fox “quitclaims to Purchaser all of Fox’s right, title and interest in and to the Motion Picture project presently entitled Watchmen, which included specifically described literary materials. Notably, the agreement provides that, “if Purchaser elects to proceed to production, the Picture shall be produced by Purchaser and shall be distributed by Fox as a Subject Picture pursuant to the terms of the Largo Agreement ...” In consideration for the rights to Watchmen, Fox was to be reimbursed for its development costs ($435,600) plus interest plus a profit participation in the worldwide net proceeds of any Watchmen picture.
Nov. 1991: The Largo Agreement was amended; Watchmen was listed as a project quitclaimed to Largo.
Nov. 1993: Larry Gordon, through Golar, withdraws from the Largo Entertainment joint venture; Largo conveys any rights it has in Watchmen to Gordon/Golar. Based on the 1991 quitclaim, the Court may infer that Gordon now stood in the shoes of Largo with respect to Watchmen and held whatever rights it acquired through the 1991 Quitclaim, which left Fox with the distribution rights it retained through that agreement.
1994: Fox negotiated a “Settlement and Release” agreement with Gordon which contemplated that the Watchmen project would be put in “perpetual turnaround” to Lawrence Gordon Productions, Inc. The “turnaround notice” gave Lawrence Gordon Productions “the perpetual right . . . to acquire all of the right, title and interest of Fox [Watchmen] pursuant to the terms and conditions herein provided.” The turnaround notice then described the formula for determining the buy-out price in the event that Gordon elected to acquire Fox’s interest. Thus, the document suggests that Gordon acquired an option to acquire Fox’s interest in Watchmen for a price. In fact, the notice obligated Gordon to pay the buy-out price on the commencement of any production of a Watchmen film. The notice also provided that the agreement was personal to Gordon and that, “prior to payment of the Buy-Out Price,” he could not assign rights or authorize any person to take any action with respect to the project.
May 2006: Warner Brothers, allegedly with knowledge of the 1991 Quitclaim, entered into a quitclaim agreement with Gordon under which it claims to have acquired the rights to the Watchmen project. Fox alleges that these facts demonstrate that, at the very least, it retained distribution rights in Watchmen, that it performed all of its obligations under the relevant agreements, and that while it granted Gordon what amounted to an option to acquire its rights, neither Gordon nor his successors ever fulfilled their contractual obligations to Fox. Indeed, Fox contends that Warner Bros either knew or turned a blind eye to the fact that Fox had retained distribution rights in the project, and that Gordon had not perfected his interest in the Watchmen project before quitclaiming it to Warner Brothers. In any event, Fox now contends that it presently holds rights in Watchmen and that Warner Brothers’ production of the Watchmen film infringes on those rights.

The judge decided that Fox had sufficient reason to state its claims for both copyright infringement and interference with contract so he didn't dismiss the lawsuit.