VW could pay up to $440m (£250m) for a 30% stake in Proton, the Reuters news agency said.
The Malaysian government owns a 42.7% share in Proton through its investment arm Khazanah Nasional.
Proton has been finding it difficult to match its Japanese and South Korean rivals, and has seen its domestic market share fall to 30% from 57% in the early 1990s.
A deal with VW would give Proton access to the German company's technology. VW, in turn, would obtain greater access to Asian markets, which last year accounted for less than 7% of its sales.