The devices, about the size of an eyelash, would be implanted into patients' tumours, where they could "spy" on a cancerous growth's activity.
Experts believe the development would allow doctors to administer radiotherapy and, in time, chemotherapy where and when it is most needed, ultimately improving recovery rates.
Professor Alan Murray, of the University of Edinburgh's school of engineering, who is leading the study, said: "Experts including scientists, engineers, clinicians and social scientists will be working to target cancer, one of the biggest health concerns of today, in an entirely new way.
"Our aim is, in the long term, to help to alleviate suffering and to improve the outlook for very many cancer patients."
The miniature chips will be designed to measure vital factors about tumours, such as their levels of blood oxygen and key biological molecules. The information would then be transmitted wirelessly to medical staff.
The readings would enable doctors to target stubborn areas of a tumour that need more intensified radiotherapy.
Sensors would also measure how effective any treatment is in killing cancer cells, enabling therapy to be personalised to individual patients.
Prof Murray said: "What we do at the moment with radiotherapy is rather like night-time bombing.
"We apply radiotherapy to the area where the tumour is, on a regular schedule.
"What these sensors will do is it to say 'the tumour needs radiotherapy of greater intensity at this particular point right now'. It's almost like a pinpoint strike with a guided missile.
"It's a change from knowing where the tumour is and irradiating it, to knowing precisely which bits of the tumour are radio-resistant at any moment in time and selectively treating them with radiation."
The University of Edinburgh team is working with experts at the city's Heriot-Watt University to develop the technology, which they hope to follow with clinical trials.
The work involves producing new sensors, as well as miniaturising existing sensors which can already track the likes of oxygen levels and temperature.
The project is mostly being carried out by the institutions' engineering and chemistry departments, but they will also work with the medical and veterinary schools throughout the five years.
Social scientists will be involved to examine ethics and regulations surrounding the project and to ensure that its findings are usable as soon as possible.
Prof Murray said it would be many years before the sensors are available for use in patients, but it is hoped clinical trials can begin within the next five years.
He said: "I would think optimistically at the end of the fourth year we might be able to release some devices for preliminary clinical trials, but not before then.
"Nothing's going to be available for use in clinical practice for a good number of years."
Prof Murray said the ultimate goal is to kill cancer cells and boost cancer recovery rates but he also predicts the development will change how patients receive cancer treatments.
"What it would mean for a cancer sufferer is that the pattern of radiotherapy would change," he said.
"You might have to go at different times, not at a regular schedule.
"It does mean your therapy will be more accurately targeted but you won't be getting it at 9am on a Tuesday for three weeks.
"It will be on a schedule that's determined by the tumour's activity.
"The aim is to hit the bits that are radio-resistant and therefore kill more cancer cells, thus producing a better chance of a cure.
"Ultimately that's got to be the goal."
The £5.2 million project, Implantable Microsystems for Personalised Anti-Cancer Therapy (IMPACT), is funded by the Engineering and Physical Sciences Research Council.
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