Just like Pandora's box, the cat is out of the bag and there's no putting it back in. I'm pulling this number out of my arse, but I'd say 90% of downloaded music is illegal. This is a major force for the music industry to fight, and they're not going to win if they try to fight it. So they need to come up with alternatives, everybody does, so that people can enjoy their music, and artists can survive and even get rich if they're damn good.
Paid music has to offer something more than illegal music. And right now paid music is much worse than illegal music because you're limited by DRM, the bitrate is lower, and you're left with fewer choices in digital format. The only thing paid services have going for them is that it's a little bit easier to find the music you're looking for, but it's not that bad. Just do a search on snarf-it.org or another such site.
Allofmp3.com was a paid service, but because it combined the best of both worlds (comprehensive easy to find music + totally open digital formats) they did extremly well. Honestly, the model is already there, just use the Allofmp3 format with a few tweaks here and there. Add some social aspects to the site, let artists set the prices, and boom you're ready to go. People aren't stupid, they're willing to support the artists they enjoy, so let them give support while giving them the content they want, and the money will roll in while the artists roll out their music.