The new deal would strike a major blow to City's hopes of signing the attacking midfielder, with reports in Spain claiming he will commit to Malaga until June 2018, with a buyout clause of €35million (£30m) included in the contract.
Isco, whose full name is Francisco Roman Alarcon Suarez, is believed to have a €21m (£17m) release clause in his current deal.
The 20-year-old has been linked with a host of top European clubs including City and Serie A giants Juventus.
Malaga director of football Mario Husillos: "Isco's contract renewal is in its advanced stages and should be signed shortly.
"We will be here presenting Isco very soon. We will be here shortly to announce the renewal of his contract.
"It's not renewed as yet, but I think it will be very shortly. We understand it is virtually a done deal.
"There are no sure things in football. Everything can change in an instant.
"The club's intention and what Isco has stated is that he is going to stay here; he's going to renew his contract.
"Life can also throw up a lot of surprises. That is the most conclusive statement that the club can make on the issue.
"Isco has really taken off. He's a great player and they want him at a number of clubs.
"He's a Spanish international. We intend to keep him at Málaga for as long as possible.
"Everyone wants to improve and if he continues growing like this, he'll have to go to a legendary European club. That's understandable."
Source: Manchester City MAD