Cancelo was shipped out on loan to Bayern Munich in January after being deemed surplus to requirements by Pep Guardiola.
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The full-back has been one of the most important players for City in recent seasons, but Guardiola reportedly became disappointed with his attitude following his reduced game time.
Bayern have an option to buy in the agreement worth £61.6million, but are unlikely to activate it after his failure to impress in Thomas Tuchel's side.
The Daily Telegraph report that Arsenal are keen to raid City once again this summer.
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This signings of Oleksandr Zinchenko and Gabriel Jesus helped turned them into Guardiola's biggest title rivals this season.
It looks as though City will just pip them to it, needing just one win from their final three games, but at one stage were in control of the race.
The Gunners are said to believe that their title rivals will be more reluctant to do business with them this summer considering their rise as challengers.
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Cancelo is contracted at City until 2027 and it remains to be seen if he will return to the fold under Guardiola.
Mikel Arteta is keen to strengthen at full back and another name linked is Ivan Fresneda from Real Valladolid.
They made a bid for the 18-year-old in January but that move collapsed on deadline day.
Other targets for Arsenal this summer are Declan Rice, whom they are growing increasingly confident they will be able to land and are preparing a reported bid of £92m.
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The club are also considering another bid to land Moises Caicedo from Brighton