FORTUNE — The luxury arms race among the three Persian Gulf air carriers continues to intensify, further destabilizing the dominance of U.S. and European airlines in international air travel.

Abu Dhabi-based Etihad unveiled its new cabin layout this week with a business class product that far exceeds the highest class of service on any Western airline, as well as a new first-class and premium first-class product that redefine in-flight luxury.

Western airlines are fighting back to protect their dominance in the sky, especially over the Atlantic, which, for many, continues to be their most profitable routes. But instead of offering a better hard product, Western airlines are using the courts to try to keep the Middle Eastern airlines out. While they have won some early victories, it is unlikely they can hold back the Persian Gulf luxury horde from overwhelming them, especially if they continue to offer such a substandard experience in the air.

The three Persian Gulf airlines — Emirates, Qatar Airlines, and Etihad — shocked the Western-dominated airline industry at the Dubai Airshow last year when they collectively announced they would be purchasing 355 new wide-body aircraft worth an astounding $160 billion. The record-smashing order included a mix of both Airbus and Boeing BA products and would ensure that they could eventually crush their U.S. and European counterparts in terms of efficiency, comfort, and luxury.

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But new jets apparently were just part of the equation. What the air carriers are planning for inside the jet may be what’s viewed as truly revolutionary. Etihad, the 10-year-old national carrier of Abu Dhabi, this week unveiled the cabin layout of the 10 Airbus A380s and 70 Boeing 787s it plans to receive over the next few years. What they showed was nothing less than spectacular, making their cross-desert rivals Emirates green with envy and their Western airline rivals — such as Air France/KLM, British Airways, Delta DAL , United ual , and American Airlines aal — shake in the respective boots.

The new cabin took Etihad five years to design and redefines what we think of as three-class service. For example, on the double-decker A380, Etihad devotes the entire lower level to its economy class, some 470 seats, which is more than the total number of seats offered by any U.S. airline on a long-haul flight.

With economy class covered, this allowed Etihad to devote the entire upper deck to its premium offerings, which is where the airlines make the bulk of their cash. Etihad’s new “business studio” seats, also available on its 787s, look like mini-offices in the sky, with ample storage, work and surface space, as well as a seat that converts into a flat bed of up to 80.5 inches long. First class on the A380 will consist of nine private suites with a separate reclining lounge seat and full-length bed, as well as a chilled mini-bar, personal vanity unit, and wardrobe.

But at the front of the plane, Etihad revealed the pièce de résistance, “the Residence” luxury bedroom suite. Etihad used space at the nose of the plane, which is usually wasted due to the curvature of the fuselage, to create one VIP suite with three rooms — a living area, a private bathroom (with shower), and a bedroom (see aging C-list pop star Dannii Minogue scream incessantly as she gives you a video tour). While only 125 square feet, “the Residence” is a unique product in commercial aviation. Each suite can accommodate two people, another aviation first. Oh, and each one is manned with its own private butler.

“The Residence” is aimed at plutocrats and mega-celebrities who would normally pay around $100,000 to travel private. So how much will a trip in the new suite set you back? On Etihad’s inaugural A380 route linking Abu Dhabi with London, booking the “the Residence” early next year currently costs around 25,500 pounds, or $43,000. Now, that is for the bedroom suite, which can accommodate two people, so it breaks down to around $21,500 per person. That might sound insanely expensive, since the same route in economy class costs around $1,000 per person, but it isn’t so insane given what one receives from the premium offerings available on most U.S. and European airlines. Oh, and for those who want to use their frequent flyer miles to book the residence, it’ll only cost you 4.7 million miles, plus airport fees and taxes.

Pricing on Etihad’s business and first-class cabins are comparable or even lower than what is being offered by Western airlines, with one of the A380s first class cabins going for around 4,600 pounds, or $8,000, roundtrip on the London to Abu Dhabi route.

Etihad plans on flying the A380 to London, Paris, New York, Melbourne, and Sydney. The airline will fly its new Boeing 787 Dreamliner directly to the U.S. starting next year. One of the first 787 routes, linking Washington, D.C. (Dulles) to Abu Dhabi, is available for purchase now. That flight won’t offer “the Residence” suite, as the plane is too small, but it will offer first and business class cabins. First class on that flight will set one back a cool $21,000, roundtrip.

Not to be outdone, Emirates announced this week that it too will be sprucing up its premium offerings, which are already arguably the world’s most luxurious. After all, this was the airline to first offer passengers an onboard shower and a partitioned suite. But compared with what Etihad just revealed, Emirate’s first class looks downright pedestrian.

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Most of the flying public will never see the inside of a premium cabin, but for those that do, Etihad, Emirates, and Qatar will soon be offering a hard product that will convince many to never consider flying a Western airline ever again. To be fair, the Western airlines that still offer first class, like Air France, do it very well, providing passengers with personalized service and a serene atmosphere. But first class on Western airlines now looks like business class in comparison to what will be offered by the Persian Gulf carriers.

Most U.S. airlines have either scaled back or completely eliminated first class and now only offer subpar business class on long-haul flights. Business class on U.S. airlines can’t even compare to the equivalent product on the European air carriers, let alone to what will be offered by the Persian Gulf carriers. Unionized, gruff, and old flight attendants serve the equivalent of slop and sparkling wine in the premium cabin on U.S. airlines. You’ll be lucky to even have a fully flat bed, Wi-Fi, or on-demand entertainment on your flight. Heck, you’ll be lucky to have a plug to power your laptop. And the jet you’ll be on will probably be only a decade or two old — if you’re lucky.

Western airlines could get away with offering subpar service in the past because they dominated the most heavily traveled and most profitable of international routes, the transatlantic paths linking the U.S. and Europe. The Western carriers have over the years gained clearance from antitrust authorities on both sides of the Atlantic to legally collude on prices to maintain their controlling position. The consolidation of the old mainline U.S. carriers has made the situation even worse, offering passengers fewer options.

But that could all change in the next few years as the Persian Gulf carriers start to take possession of the hundreds of new wide-body aircraft they have ordered. For now, they are operating from points connecting their Middle Eastern hubs in the Persian Gulf but they probably won’t stay cloistered in the desert for too long. Emirates last year launched a test flight linking Milan with New York, threatening Western air carriers on this important transatlantic route. Immediately, prices for tickets across all classes collapsed as Emirates introduced real competition on a transatlantic route for the first time in years.

But instead of fighting Emirates with better service or a better product, Western air carriers decided to fight the Persian Gulf luxury horde through the courts. Assaereo, an Italian airline trade group backed by Alitalia, filed suit to shut down Emirates’ transatlantic route, claiming it violated a bilateral air-service agreement between Italy and the United Arab Emirates. Last month, an administrative court in Rome ordered that the flight be discontinued. For now, though, Emirates seems to be ignoring the court order and continues to fly the route. There is talk that either Emirates or Etihad will simply buy Alitalia and gain unfettered access to Europe via Rome and Milan. Whether or not the Italian government or the EU would approve such a sale is unclear.

In either case, though, Emirates seems determined to expand its transatlantic presence and isn’t going to let an administrative court in Rome stand in its way. Tim Clark, Emirate’s chief executive, told the Wall Street Journal last month that the airline has been approached by airport officials in Germany, Spain, the United Kingdom, Sweden, and Denmark on launching transatlantic routes. If true, Emirates, along with the rest of the Persian Gulf airlines, would be able to offer a real alternative to the current transatlantic oligopoly of the Western carriers. And with all of the airlines backed by their respective Sheikdoms, they would be able to hang in a price war far longer than any of the publicly traded Western carriers.

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This is the Western carriers’ biggest fear. Indeed, the U.S. mainline carriers just started to make decent profits after years of crippling competition — they’d hate to go back into the red. They used to count on their frequent flyer loyalty programs and high flight frequencies to kill any competition from startup carriers, but with recent service and cost cuts, they can no longer rely on either to keep competition at bay.

If they can’t stop the Persian Gulf luxury horde in the courtroom, the Western carriers will need to change how they do business. One thing they can do right now is boost service quality for premium cabins and convince people once again that their loyalty plans can pay real dividends. Establishing brand loyalty early is critical.

With higher profits, U.S. airlines should reinvest in their offerings. Some, like United, are slowly upgrading their “Business First” premium product on their transatlantic routes, but they are doing the bare minimum. Premium passengers want to be wowed. Offering cashews instead of peanuts in first class simply isn’t going to do it — at least not anymore.