The 24-year-old spent last season on loan at the Emirates Stadium, and although his performances dipped under Unai Emery, he became a vital fixture in the midfield following the arrival of new coach Mikel Arteta.
Arsenal are keen to extend Ceballos' stay in north London for another year, and they were in talks with Madrid over a possible deal. But the departure of former head of football Raul Sanllehi, who had been leading the discussions, has caused any possible transfer to stall - a development which has caught the eye of Serie A side Milan, according to The Telegraph.
Chief executive Vinai Venkatesham is now the man in charge of negotiating a move with los Merengues, and the change in personnel has not put the Gunners out of the race. But this temporary hitch has allowed I Rossoneri to spy their own chance at luring the Spaniard to San Siro, and he would be a major coup for the Italian side.
Milan coach Stefano Pioli is looking to strengthen his midfield options for the upcoming season, and Ceballos would certainly provide some class on the ball and elite level experience in this current squad.
Having been the clear frontrunners prior to this hiccup, Arsenal now face a battle to retain the midfielder's services for a second season. Ceballos played in all but three matches for the Gunners following football's restart, leading Arteta's men to FA Cup glory with a 2-1 win over Chelsea in the final.
The Gunners' boss is very keen for his national compatriot to guide this new-look Arsenal side into next season, and failure to tie him down to a new deal would come as a significant blow to their Champions League ambitions.