Menlo Park start-up Xfire, which does instant messaging for online gaming, is sparking a fire at the DEMO conference currently underway.

The company has gained such traction — recently hitting 1 million users — that jealous incumbent Yahoo is turning its sights on the company. Yahoo is suing Xfire for patent infringement, details here. Apparently, one of Xfire’s employees, Chris Kirmse, helped developed a patent while formerly employed at Yahoo. Ownership of inventions is supposed to remain with the company worked for, not with the inventor — at least, that is what is often agreed to in employment contracts.

Yahoo’s GameProwler allows players to use a game server in connection with a messenger server to let ‘buddies’ to know when other ‘buddies’ are playing games online, and easily join them. That’s very similar to what Xfire is doing. Xfire apparently came out with more features yesterday — allowing gamers to message each other even when they’re playing different games, and making itself “skinnable”. Jeffrey Nolan, of SAP Ventures, also has a tidbit here, on why Xfire is relevant.

Some great live-blogging going on by Nolan, while Om harrumphs about the whole DEMO conference.

Here’s Xfire’s venture capital funding announcement from last year.