Canberra has introduced hardline policies to stem the influx of asylum-seekers reaching its shores on people-smuggling boats, with those arriving by sea denied resettlement in Australia even if found to be genuine refugees.
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Instead they are turned back to their country of departure or sent to the tiny state of Nauru and Papua New Guinea's Manus island.
Indonesia, a major transit point for asylum seekers en route to Australia, has long been riled by the tough approach, particularly the policy of turning migrant boats back to the archipelago when it is safe to do so.
However ties between the neighbours have been improving following a series of crises, and Indonesia's security ministry said Jakarta was considering a proposal from Australia to use an island in the archipelago to house asylum-seekers.
"It was an idea proposed by Australia," spokesman Agus Barnas told AFP. "We said we will discuss this again when we meet with them in December."
"It's not final, it is an option we are considering," he added.
Jakarta entered into a similar scheme in the past, hosting about 200,000 Vietnamese on Galang island off Sumatra between 1979 and 1996, after many fled the country by boat following the Vietnam War.
Security Minister Luhut Panjaitan earlier told the Jakarta Post newspaper that Australia would be "required to entirely finance" the new scheme, and added talks about it were "preliminary".
He said that many asylum-seekers ended up stuck in Indonesia's poorer provinces and could create tensions with local residents, according to the newspaper.
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Panjaitan said asylum-seekers should only be housed temporarily on the island, and did not indicate which island it would be.
The development came after Luhut made a trip to Australia earlier this week and ahead of a return visit from Australian officials to Indonesia in the coming weeks.
However, the minister also demanded that Australia end its policy of turning boats back to Indonesia.
"I told them that such actions are wrong and against humanitarian principles," he said.
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Canberra has made no secret of the fact that it is in talks with a number of countries about taking refugees now living on the two Pacific islands.
The news about the island talks came as Australian officials refused to confirm reports that a boat carrying asylum-seekers was being towed away from its Indian Ocean territory of Christmas Island.
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