It follows the successful development of a smaller-scale floating wetland on another Rotorua lake, Rotoehu, this year.
Rotorua mayor Kevin Winters said the building of a large-scale wetland was an environmental consent requirement to compensate in part for reducing an area of land-based wetlands when the city's airport runway was extended recently.
Rotorua District Council's investment in the project would be $450,000.
"Because floating wetlands have proved substantially more effective as environmental remediation tools, this project's focus is on a lake-based wetland device rather than land-based wetlands," Mr Winters said.
"To maximise effectiveness it needs to have 'cut out' areas within the island so we are taking the opportunity to form these into the shape of the letters that make up the word 'Rotorua' - the name of the district and the lake.
"To our knowledge this concept will be a world first, as well as the largest project of its type in the world."
The wetland is expected to be complete by the end of the year.