I just created a MS free tier instance and found it was using Windows Datacenter edition. If I recall, with DC edition, if you buy a DC edition licence for a physical server and run only Hyper-V hypervisor role on it, you can have unlimited number of virtual servers on it for free. I'ts possible Amazon is using this licencing clause to their advantage.

I doubt MSFT would subsidize the cost, they are competing with Azure.

Think about how they make money from Android while competiting with Windows Phone. They're clever enough to realise you can make money from multiple angles.

You can get a free 3-month trial of Azure:

http://www.windowsazure.com/en-us/pricing/free-trial/

or

if you get into the bizspark program you can get a much larger endowment from MS

http://www.windowsazure.com/en-us/pricing/member-offers/

If they are, I'd see it the same way as funding the node port. The less temptations for developers to build on *nix, the better for Microsoft. Using Windows on EC2 means they're still using Windows, after all.

I'd imagine they'd prioritize lowering the barrier of creating .net webapps over Azure success. Azure is just one service but .net success is key part of their strategy.