As luminaries and pundits meet this week at the third annual Web 2.0 Conference, the Internet sector faces rotund challenges and exciting opportunities.

The event is being held in San Francisco at a critical time for the web. Opportunities to extend the success of the past four years are plentiful, experts say.

Bu the danger entrepreneurs have to worry about is that their companies need to be “Web 2.0 and not Web 1.1”, said Munjal Shah, co-founder and chief executive officer of Riya, which has attracted much attention because its search engine is based on image processing and recognition, instead of on indexing of photos' text metadata.

"A lot of people are jumping into the Internet space and investing in it aggressively, so you're seeing companies getting funded that maybe shouldn't be getting funded. This is creating a hyper and unhealthy environment," said Eric Chin, a partner at early-stage venture capital firm Bay Partners. This is a recent phenomenon, enabled by the low costs of hardware, software and bandwidth required to launch an Internet company, Chin says. This low-entry barrier is crowding the Internet market, and creating potential problems.

He sees big opportunities in what he calls "individual self expression" websites like Second Life, whose users are willing to pay to create virtual identities.

Another area that offers an opportunity to innovate and solve a pressing need is in the control of spam in blogs and social networks, said Toni Schneider, chief executive officer of Automattic Inc. Spam can overrun these sites and ruin them. "Just like spam threatened to make e-mail useless, the biggest threat facing Web 2.0 is spam," says Schneider, whose company makes the Wordpress blogging software and the Akismet blog spam-filtering service.

Various areas of vertical search, as well as next-generation ad networks are ripe with opportunity, said Jeff Crowe, general partner at Norwest Venture Partners, a venture capital firm.

And industry analyst Greg Sterling of Sterling Market Intelligence said mobile Web 2.0 services will rock the market: "Mobile is the next big thing that will be disruptive and unleash innovation. It's the next big opportunity," he said.

Ultimately, what will keep Web 2.0 on track and prevent it from derailing is a vigorous culture of innovation, which could suffer if big companies start buying startups without rhyme or reason and then, not knowing what to do with them, stifle their innovative spirit, experts say. Another danger to innovation could come from a glut of startups that confuse investors and users, so that companies with truly good ideas get lost in the shuffle.