Sri Lanka on Thursday granted permission for China to build a vast "port city" in the island's capital, despite concerns the ambitious project could be an environmental disaster.

President Maithripala Sirisena had suspended the contentious $1.4 billion plan to build on reclaimed land next to Colombo's main harbour, shortly after taking power in January last year.

But the port city, initiated by Chinese President Xi Jinping in September 2014 and expected to include real estate, a marina and a Formula One racetrack, has again been given the green light.

"The Cabinet Committee on Economic Management has recommended allowing resumption of the project subject to limitations and conditions stipulated in the EIA (environmental impact assessment)," the government said in a statement.

It did not say what the conditions were, but official sources told AFP that Chinese investors were given permission to resume work on the project without any major modifications.

Prime Minister Ranil Wickremesinghe has said reclaiming land next to the harbour could trigger erosion along the island's western coastline and threaten its vital tourist industry.

The project, funded by Chinese state-owned company China Communications Construction, represents the biggest single foreign investment ever received by Sri Lanka.

It will add 233 hectares (575 acres) of new real estate in the congested capital.

Sirisena's government had ordered a review of all big-ticket construction projects signed by his predecessor Mahinda Rajapakse, who is under investigation over allegations of corruption during his decade in power.

Rajapakse relied heavily on China to rebuild the country's infrastructure after the end of the island's decades-long ethnic war in May 2009.

China, the largest single lender to Sri Lanka, secured contracts to build roads, railways and ports under the Rajapakse regime.

However, the present administration has accused the previous government of agreeing to unfavourable terms for the Chinese loans.

Sirisena's government is seeking an International Monetary Fund bail out of an unspecified amount of money to bolster the island's foreign reserves.

Beijing has been accused of seeking to develop facilities around the Indian Ocean in a "string of pearls" strategy to counter the rise of rival India and secure its own economic interests.