<PAGE>
                                                                    Exhibit 10.3

CONFIDENTIAL TREATMENT HAS BEEN REQUESTED AS TO CERTAIN PORTIONS OF THIS
EXHIBIT, WHICH PORTIONS HAVE BEEN OMITTED AND REPLACED WITH [****] AND FILED
SEPARATELY WITH THE SECURITIES AND EXCHANGE COMMISSION.

                              SETTLEMENT AGREEMENT
                               AND MUTUAL RELEASE

      THIS SETTLEMENT AGREEMENT AND MUTUAL RELEASE ("SETTLEMENT") is made and
entered into as of July 25, 2003 (the "EFFECTIVE DATE"), by and between
Microsoft Corporation, a Washington corporation with principal offices in
Redmond, Washington (hereinafter "MICROSOFT") and Immersion Corporation, a
Delaware corporation with principal offices in San Jose, California (hereinafter
"IMMERSION"), each a "PARTY" and collectively, the "PARTIES."

                                    RECITALS

      WHEREAS, Immersion filed an action in the United States District Court for
the Northern District of California entitled Immersion Corporation v. Sony
Computer Entertainment of America, Inc., Sony Computer Entertainment Inc., and
Microsoft Corporation, Northern District of California Case No. C02-00710 CW
(WDB) (the "LAWSUIT");

      WHEREAS, in the Lawsuit Immersion alleged infringement of U.S. Patent Nos.
5,889,672 and 6,275,213, and thereafter on October 8, 2002 Immersion filed a
First Amended Complaint withdrawing the allegations of infringement under U.S.
Patent No. 5,889,672 and adding allegations of infringement under U.S. Patent
No. 6,424,333 (U.S. Patent Nos. 6,275,213 and 6,424,333 shall be referred to as
the "PATENTS-IN-SUIT");

      WHEREAS, Microsoft filed various counterclaims in the Lawsuit alleging
invalidity, non-infringement, and unenforceability of the Patents-in-Suit; and

      WHEREAS, Microsoft and Immersion wish to settle the Lawsuit insofar as it
involves claims or disputes between Immersion and Microsoft, including all
claims and counterclaims made or that could have been made by or against
Microsoft in, or in connection with, the Lawsuit (such claims by or against
Microsoft are referred to as the "MICROSOFT LAWSUIT").

      NOW, THEREFORE, in consideration of the mutual covenants, agreements and
understandings hereinafter contained, and for good and valuable consideration,
the Parties hereto agree as follows:

                                      TERMS

      1. LICENSE. Simultaneously with the execution of this Settlement, the
Parties shall enter into the License Agreement attached as Exhibit A (the
"LICENSE AGREEMENT").

      2. PAYMENT AMOUNT. Within five (5) days after the Effective Date,
Microsoft shall pay Immersion by cashier's check, wire transfer or other
immediately available funds the sum of money set forth in the License Agreement.
<PAGE>
                              PROVIDED UNDER RULE 408

      3. TERMINATION OF THE MICROSOFT LAWSUIT. In consideration of the payments
made under the License Agreement and upon verification of Immersion's receipt of
the wire transfer for the amount set forth in the License Agreement and the
Purchase Price (as defined in the Stock Purchase Agreement executed
contemporaneously with this Settlement) (the "PAYMENT DATE"), the Parties will
immediately jointly file stipulations of dismissal of the Microsoft Lawsuit with
prejudice in the form attached hereto as Exhibit B with the clerk of the United
States District Court for the Northern District of California. This Settlement
is final and binding upon the Parties as of the Payment Date. Immersion and
Microsoft agree to each bear their own expenses, legal costs and attorneys' fees
stemming from the Microsoft Lawsuit up through and including the Payment Date.

      4. CLAIMS. Each Party represents and warrants that as of the Effective
Date it has not assigned or otherwise transferred or subrogated any interest in
any of its claims that are the subject of this Settlement, whether voluntarily,
involuntarily or by operation of law. Each Party agrees to indemnify, defend and
hold any other Party harmless from any liability, loss, claims, demands,
damages, costs, expenses or attorneys' or experts' fees incurred as a result of
its breach of any of the representations and warranties set forth in this
Section 4.

      5. GENERAL RELEASE. Effective as of the Payment Date, Microsoft, on behalf
of itself and its current and future officers, directors, agents, shareholders,
attorneys, insurers, employees, successors, assigns, parent companies,
subsidiaries, divisions, affiliates, and representatives, and Immersion, on
behalf of itself and its current and future officers, directors, agents,
shareholders, attorneys, insurers, employees, successors, assigns, parent
companies, subsidiaries, divisions, affiliates, and representatives, each hereby
mutually release and forever discharge the other Party (and the other Party's
current and future officers, directors, employees, attorneys, successors,
assigns, subsidiaries, divisions and affiliates) from any and all liability and
claims, debts, rights, actions, suits, damages, losses, costs, expenses, and
demands whatsoever, in law or equity, of every kind, nature or description,
whether known or unknown, fixed or contingent, which Microsoft or Immersion, as
the applicable releasing Party, now has, or may hereafter acquire, by reason of
any matter, cause or thing whatsoever accruing, occurring, or arising at any
time prior to the Payment Date.

      6. JOINT PRESS RELEASE. The Parties shall issue, between 12:01 a.m. and
1:30 p.m. Pacific Time on July 28, 2003, the mutually-agreed-upon joint press
release attached hereto as Exhibit C.

      7. NO ADMISSION OF WRONGDOING. This Settlement does not constitute and
shall not be construed as an admission or acknowledgment of any wrongdoing by
any Party, including but not limited to patent infringement by Microsoft.

      8. MUTUAL RELEASE OF ALL CLAIMS. Effective as of the Payment Date,
Microsoft, on behalf of itself and its current and future officers, directors,
agents, shareholders, attorneys, insurers, employees, successors, assigns,
parent companies, subsidiaries, divisions, affiliates, and representatives, and
Immersion, on behalf of itself and its current and future officers, directors,
agents, shareholders, attorneys, insurers, employees, successors, assigns,
parent companies, subsidiaries, divisions, affiliates, and representatives, each
hereby mutually release and forever discharge the other Party (and the other
Party's current and future officers, directors, employees, attorneys,
successors, assigns, subsidiaries, divisions and affiliates) from any and all
liability and

                                      -2-
<PAGE>
                              PROVIDED UNDER RULE 408

claims, debts, rights, actions, suits, damages, losses, costs, expenses, and
demands whatsoever, in law or equity, of every kind, nature or description,
whether known or unknown, fixed or contingent, which Microsoft, Immersion, or
any of them ever had, now has, or may hereafter acquire, by reason of any
matter, cause or thing whatsoever accruing, occurring, or arising at any time
prior to the Payment Date ("CLAIMS"), and solely to the extent that such Claims
arise from, refer to, or in any manner relate to any of the complaints,
cross-complaints or counterclaims that were filed in the Microsoft Lawsuit.
Immersion's release under this Settlement shall inure to the benefit of the
licensees, distributors and customers, direct and indirect, of Microsoft and all
Microsoft Subsidiaries (as defined in the License Agreement) (collectively,
"MICROSOFT CUSTOMERS") solely with respect to (i) any hardware, software,
service or associated component licensed, manufactured, distributed, published,
or sold by or for Microsoft or a Microsoft Subsidiary which is either (a)
distributed or sold in the form created by or for Microsoft or a Microsoft
Subsidiary, or (b) incorporated into the products or components of Microsoft
Customers; and (ii) any game, other than a Medical Product (as defined in the
License Agreement), developed by a third party prior to the Payment Date and
licensed for use on a [****] (as defined in the License Agreement). However,
notwithstanding anything to the contrary herein, in no event shall the release
by Immersion set forth in this Settlement be construed [****] or to third
parties to the extent that such third parties make products or provide services
designed specifically for, or specifically for use in conjunction with the
products, of the foregoing entities.

      9. REPRESENTATION BY COUNSEL. Immersion and Microsoft have both been
represented by counsel in entering into this Settlement and the Exhibits,
counsel has reviewed the Settlement, including the Exhibits, and advised as to
any and all risks, and Immersion and Microsoft each freely enter into this
Settlement.

      10. WAIVER OF SECTION 1542. It is understood and agreed that this
Settlement is intended to cover and does cover all claims or possible claims of
every nature and kind whatsoever arising prior to the Effective Date, whether
known or unknown, suspected or unsuspected, or hereafter discovered or
ascertained, and all rights under Section 1542 of the Civil Code of California
are hereby expressly waived. The Parties hereto acknowledge that they are
familiar with Section 1542, which reads as follows:

            A GENERAL RELEASE DOES NOT EXTEND TO CLAIMS WHICH THE CREDITOR DOES
            NOT KNOW OR SUSPECT TO EXIST IN HIS FAVOR AT THE TIME OF EXECUTING
            THE RELEASE, WHICH IF KNOWN BY HIM MUST HAVE MATERIALLY AFFECTED HIS
            SETTLEMENT WITH THE DEBTOR.

The Parties hereto expressly, knowingly, and intentionally waive and relinquish
any and all rights which they have under Section 1542, as well as under any
other similar state or federal statute or common law principle.

      11. CONFIDENTIALITY OF THIS SETTLEMENT. The Parties shall use their best
efforts to keep the terms and conditions of this Settlement in strict
confidence, and neither Party shall, without first securing the written consent
of the other Party, knowingly disclose any of the terms and conditions of this
Settlement to any non-affiliated third party or make any such disclosure in


                                      -3-
<PAGE>
                              PROVIDED UNDER RULE 408

any public announcement, press release, or publication, or in any publicity,
advertising or promotional activity, except as follows or as additionally
permitted under the License Agreement, but only to the extent specifically
authorized under the License Agreement: (a) in the joint press release as
provided for in this Settlement; (b) disclosures required by law, government
regulation, or court order, including, but not limited to, any securities laws
or Securities and Exchange Commission rules or regulations; (c) necessary
disclosures to the Party's directors, accountants, legal advisors, investors,
and financial advisors; and (d) disclosures necessary to bring an action to
enforce this Settlement. The restrictions of this Section 11 shall not prevent
either Party from disclosing the fact of settlement, and that they have resolved
all disputes regarding the Microsoft Lawsuit, or representing that Microsoft has
clear rights to all intellectual property in its products, nor shall they apply
to any information which now is or hereafter becomes publicly available except
through a violation of this Section 11.

      12. CONFIDENTIALITY OF PROPRIETARY INFORMATION. Except as may reasonably
be agreed to in writing within thirty (30) days of the Payment Date by counsel
for the Parties, Immersion and Microsoft expressly agree to destroy any
information marked as "Confidential" or "Attorneys Eyes Only" pursuant to the
Stipulated Protective Order entered on September 23, 2002 and the Stipulation
and Order Revising Protective Order entered on March 6, 2003 (collectively,
"PROTECTIVE ORDER") in the Microsoft Lawsuit. Each of Immersion and its counsel
and Microsoft and its counsel agrees to provide the others with a sworn
statement that all documents produced by one Party to the other subject to the
Protective Order have either been destroyed or returned to the producing Party
within sixty (60) days of the Effective Date. Immersion further agrees to return
all source code provided to Immersion under the Protective Order (whether
existing in electronic or paper form) within thirty (30) days after the
Effective Date and to provide Microsoft with a sworn statement from an officer
of Immersion that (i) no unauthorized copies of such source code were made while
in Immersion's possession; and (ii) all such source code has been returned to
Microsoft. In no event will any agreement between the Parties' counsel with
respect to any information that Immersion may retain pursuant to the first
sentence of this Section 12 extend to any Microsoft source code (whether
existing in electronic or paper form).

      13. DISPUTE RESOLUTION. This Settlement shall be construed and controlled
by the laws of the State of Washington, and each Party consents to exclusive
jurisdiction and venue in the federal courts sitting in King County, Washington,
unless no federal subject matter jurisdiction exists, in which case each Party
consents to exclusive jurisdiction and venue in the Superior Court of King
County, Washington. Each Party waives all defenses of lack of personal
jurisdiction and forum non-conveniens. Process may be served on either Party in
the manner authorized by applicable law or court rule. In any action to enforce
any right or remedy under this Settlement or to interpret any provision of this
Settlement, the prevailing Party shall be entitled to recover its reasonable
attorneys' fees, costs and other expenses.

      14. NOTICE. All notices and requests in connection with this Settlement
will be given in writing and will be deemed given as of the day they are
received either by messenger, delivery service, or in the mails of the United
States of America, postage prepaid, certified or registered, return receipt
requested, and addressed as follows:



                                      -4-
<PAGE>
                               PROVIDED UNDER RULE 408

   TO: MICROSOFT                                    TO: IMMERSION
   Microsoft Corporation                            Immersion Corporation
   Attention:  Vice President, Litigation           Attention:  Vice President,
                                                    Legal Affairs
   One Microsoft Way                                801 Fox Lane
   Redmond, Washington  98052-6399                  San Jose, California 95131
   Phone: (425) 882-8080                            Phone:  (408) 467-1900
   Fax: (425) 936-7329                              Fax:  (408) 467-1901
   Copy to: Law & Corporate Affairs
   Attention:  Vice President, Intellectual
   Property
   Fax:  (425) 936-7409

or at such other address as either Party hereto may specify by notice given in
accordance with this Section 14.

      15. ASSIGNMENT. This Settlement, including all releases and covenants not
to sue by Immersion of or to Microsoft, are fully assignable by Microsoft, other
than to [****] and provided such assignment is made in connection with an
assignment of all rights and obligations under the License Agreement. This
Settlement, including all releases and covenants not to sue by Microsoft of or
to Immersion, may be assigned by Immersion to any acquiror of all or
substantially all of the business or assets of Immersion, or in connection with
a merger. This Settlement will be binding upon and inure to the benefit of the
successors and assigns of the Parties. Notwithstanding anything to the contrary
in this Settlement, in the event of any permitted assignment by a Party pursuant
to this Section 15, in no event will the assignee be deemed to have released any
claims other than the claims of the assigning Party (i.e. Microsoft or
Immersion) which are expressly released by the assigning Party hereunder. If
Immersion is acquired by Company X, in no event will Company X be deemed to have
released any claims that it possessed prior to the acquisition of Immersion or
that are independent of or unrelated to Immersion.

      16. SEVERABILITY. If any provision of this Settlement shall be held to be
illegal, invalid or unenforceable, that provision will be enforced to the
maximum extent permissible so as to effect to the intent of the Parties, and the
validity, legality and enforceability of the remaining provisions shall not in
any way be affected or impaired thereby. Each Party hereby waives its right to
challenge the validity and enforceability of this Settlement.

      17. CONSTRUCTION. This Settlement has been negotiated by the Parties and
their respective counsel and will be fairly interpreted in accordance with its
terms and without any construction in favor of or against any Party. Failure by
either Party to enforce any provision of this Settlement will not be deemed a
waiver of future enforcement of that or any other provision hereof.

      18. COUNTERPARTS. This Settlement may be executed by the Parties in
separate counterparts, each of which so executed and delivered shall be an
original. Delivery by facsimile shall be sufficient for purposes of this
paragraph.

                                      -5-
<PAGE>
                             PROVIDED UNDER RULE 408

      19. RECITALS AND EXHIBITS. The recitals and exhibits are hereby
incorporated into this Settlement by this reference.

      20. ENTIRE AGREEMENT. This Settlement, together with the Exhibits hereto,
which are hereby incorporated into and made a part of this Settlement, contain
the entire and only agreement between the Parties with respect to the subject
matter hereof and thereof, and supersede and cancel all previous and
contemporaneous oral and written agreements, discussions, communications,
negotiations, commitments and writings in connection with such subject matter.
The terms and conditions of this Settlement may be altered, modified, changed or
amended only by a written agreement executed by duly authorized representatives
of Immersion and Microsoft.

      21. AUTHORIZED SIGNATORIES. The Parties hereby warrant that they are
legally authorized and entitled to settle and release every claim herein
referred to and as provided by this Settlement, and to give a valid, full, and
final acquittance therefor.



                            [SIGNATURE PAGE FOLLOWS]



                                      -6-
<PAGE>

                   -------------------------------------------

                              SIGNATURE PAGE TO THE

                     SETTLEMENT AGREEMENT AND MUTUAL RELEASE

                   -------------------------------------------



      IN WITNESS WHEREOF, the Parties have executed this Settlement on the dates
opposite their respective signatures and have read and fully understand the
provisions of this Settlement.

IMMERSION CORPORATION

By:                                              Dated:
    ---------------------------------------             ------------------------
     VICTOR VIEGAS
     President, Chief Executive Officer and
     Chief Financial Officer

MICROSOFT CORPORATION

By:                                              Dated:
    ---------------------------------------             ------------------------
     Name:
     Title:


By:                                              Dated:
    ---------------------------------------             ------------------------
     Name:
     Title:


By:                                              Dated:
    ---------------------------------------             ------------------------
     Name:
     Title:


By:                                              Dated:
    ---------------------------------------             ------------------------
     Name:
     Title: