Speaking to CNBC’s Bernie Lo, Rudd said, “If we can possibly agree on a joint exploration extraction entity which distributes the wealth resources which lie there around the region, that might help solve the sovereignty question.”

He added that "this will buy time for now,” and the nations can wait for the next generation of leaders to find a solution to the problem.

The islands called Diaoyu in China and Senkaku in Japan are claimed by both countries. Two weeks ago Japan purchased the islands from a private owner that sparked wide protests in China, forcing many Japanese firms to shut down operations there.

China's Foreign Minister Yang Jiechi and his Japanese counterpart Koichiro Gemba met Tuesday for about one hour on the sidelines of the U.N. General Assembly in New York to discuss the situation but did not reach any conclusion.

Tensions between the two nations come at a time when China is preparing for a once-in-a-decade political transition. The international community is awaiting signs from the new leadership that China’s priority will be on economic reforms, and not military dominion, even as it stepped up its claims over the islands earlier this week by sending three Chinese ships into the waters near the islands.

Rudd said that the economic reforms in China will likely continue, with Xi Jinping emerging as the head of the new central policy-making committee within the government.

“What I sense is an overall reformist direction to leadership…not just preserving where they've gone on reforming the economy so far, but taking new steps as well in order to boost growth, bolster growth and critically bolster employment,” he added.