The new device will cost only $200 without a contract, and will be a third smaller than the iPhone 4, sources close to the company have told news agency Bloomberg.
The new iPhone has no home button, and may support a new "universal SIM" that allows users to switch their phone network without having to swap the SIM card.
The "iPhone mini" is intended to put the brakes on Android's explosive growth in the budget smartphone market. Android recently overtook Symbian as the most popular smartphone OS, and Apple believes it has an opportunity to move into this high volume market.
"Instead of targeting 25% of the global mobile-phone market, Apple would be going after 100%,” Charlie Wolf, an analyst at Needham & Co told Bloomberg.
The report claims the device could arrive on the market this summer, although launch plans haven't been confirmed. Apple, naturally, declined to comment on the speculation.
The news has been leaked on the same day that Nokia will unveil its new smartphone strategy.