Gunners manager Arsene Wenger will be handed a £70m transfer budget to gear up the squad for next season, and the Arsenal boss is believed to have prioritised the signing of the 20-year-old attacking midfielder.
Arsenal are set to go another season without a trophy - their eight consecutive - and there is a growing feeling at the Emirates Stadium that they will have to splash out to compete with the top Premier League clubs.
Currently fifth in the Premier League, the Gunners risk missing out on Champions League qualification for the first time under Wenger.
Isco is valued at £30m by his club, almost double Arsenal's transfer record. The north London outfit have done business with Malaga over the past 12 months, signing Santi Cazorla and Nacho Monreal.
Isco has received a glowing recommendation from Monreal, and Gunners chief scout Steve Rowley has watched him play on more than one occasion.
The report claims Arsenal have held initial talks with Malaga, who progressed to the Champions League quarter-final with a 2-1 aggregate victory over Porto earlier this week.
But Isco is one of Europe's hottest prospects, and the Gunners could face an uphill battle to clinch the signing if they fail to finish in the top four this season. Manchester City were reportedly among the favourites to sign the youngster in the summer.
He made his Spain debut last month, coming on as a substitute during his country's 3-1 win over Uruguay.