The success of Pong resulted in Bushnell pushing his employees to create new products. In 1974, Atari engineer Harold Lee proposed a home version of Pong that would connect to a television. The system began development under the codename Darlene, named after an attractive female employee at Atari. Alcorn worked with Lee to develop the designs and prototype, and based them on the same digital technology used in their arcade games. The two worked in shifts to save time and money; Lee worked on the design's logic during the day, while Alcorn debugged the designs in the evenings. After the designs were approved, fellow Atari engineer Bob Brown assisted Alcorn and Lee in building a prototype. The prototype consisted of a device attached to a wooden pedestal containing over a hundred wires, which would eventually be replaced with a single chip designed by Alcorn and Lee; the chip had yet to be tested and built before the prototype was constructed. The chip was finished in the latter half of 1974, and was, at the time, the highest performing chip used in a consumer product.
Bushnell and Gene Lipkin, Atari's vice-president of sales, approached toy and electronic retailers to sell Home Pong, but were rejected. Retailers felt the product was too expensive and would not interest consumers. Atari contacted the Sears Sporting Goods department after noticing a Magnavox Odyssey advertisement in the sporting goods section of its catalog. Atari staff discussed the game with a representative, Tom Quinn, who expressed enthusiasm and offered the company an exclusive deal. Believing they could find more favorable terms elsewhere, Atari's executives declined and continued to pursue toy retailers. In January 1975, Atari staff set up a Home Pong booth at a toy trade fair in New York City, but was unsuccessful in soliciting orders.
While at the show, they met Quinn again, and, a few days later, set up a meeting with him to obtain a sales order. In order to gain approval from the Sporting Goods department, Quinn suggested Atari demonstrate the game to executives in Chicago. Alcorn and Lipkin traveled to the Sears Tower and, despite a technical complication, obtained approval. Bushnell told Quinn he could produce 75,000 units in time for the Christmas season, however, Quinn requested double the amount. Though Bushnell knew Atari lacked the capacity to manufacture 150,000 units, he agreed. Atari acquired a new factory through funding obtained by venture capitalist Don Valentine. Supervised by Jimm Tubb, the factory fulfilled the Sears order. The first units manufactured were branded with Sears' Tele-Games name. Atari later released a version under its own brand in 1976.
The success of Pong attracted the attention of Ralph Baer, the inventor of the Magnavox Odyssey, and his employer, Sanders Associates. Sanders had an agreement with Magnavox to handle the Odyssey's sublicensing, which included dealing with infringement on its exclusive rights. However, Magnavox had not pursued legal action against Atari and numerous other companies that released Pong clones. Sanders continued to apply pressure, and in April 1974 Magnavox filed suit against Atari, Bally Midway, Allied Leisure and Chicago Dynamics.
Magnavox argued that Atari had infringed on Baer's patents and his concept of electronic ping-pong based on detailed records Sanders kept of the Odyssey's design process dating back to 1966. Other documents included depositions from witnesses and a signed guest book that demonstrated Bushnell had played the Odyssey's table tennis game prior to releasing Pong. In response to claims that he saw the Odyssey, Bushnell later stated that, "The fact is that I absolutely did see the Odyssey game and I didn't think it was very clever."
After considering his options, Bushnell decided to settle with Magnavox out of court. Bushnell's lawyer felt they could win, however, he estimated legal costs of US$1.5 million, which would have exceeded Atari's funds. Magnavox offered Atari an agreement to become a licensee for US$0.7 million. Other companies producing Pong clones-Atari's competitors—would have to pay royalties. In addition, Magnavox would obtain the rights to Atari products developed over the next year. Magnavox continued to pursue legal action against the other companies, and proceedings began shortly after Atari's settlement in June 1976. The first case took place at the United States District Court in Chicago, with Judge John Grady presiding. To avoid Magnavox obtaining rights to its products, Atari decided to delay the release of its products for a year, and withheld information from Magnavox's attorneys during visits to Atari facilities.