A statement of intent was announced on Monday to negotiate the potential transfer of ownership of Peat Island, on the Hawkesbury River in the Central Coast region, to Darkinjung Local Aboriginal Land Council.
The island is the site of a former asylum that was opened in 1911 and decommissioned in 2010, which has not been used since.
The Darkinjung land council's CEO Brendan Moyle told AAP the plan is to turn the island into a centre that celebrates Aboriginal culture while honouring and respecting the people who lived in the asylum.
Planning Minister Anthony Roberts said the statement of intent with Darkinjung LALC "will aim to reunite the site with the custodians of the land, ensuring it will be preserved and acknowledged well into the future".
While government proposals in recent years to develop the site have prompted community concerns, Mr Moyle says the Darkinjung council is not planning extensive new construction.
"What would we be looking to do would be to remediate the current buildings to restore them, both their heritage significance while providing the internals at modern standards," he said.
"We want to develop something that's really inclusive of both Aboriginal culture but also paying respects to what Peat Island became and what it means for the broader community."
Accommodation on the island or nearby would allow tourists to use the island as a gateway to explore sites up and down the river, Mr Moyle said.
Darkinjung LALC and the NSW government will continue working through the planning processes, including community consultation.
