United manager Sir Alex Ferguson has said the confrontation with Liverpool is the biggest in club football. But Pallister told BBC Sport: "City have jumped over United in the Premier League table and proved they are going to be serious title rivals this season. "This might become the big game for United more than Liverpool."
The former Old Trafford centre-half added: "It was only a matter of time [before City challenged for the title] with the money they have spent and the set-up they are establishing there. "It is all set up for an absolute cracker because both teams have also been in decent form.
"For many years it has been the Liverpool game that has been the stand-out fixture for United, but maybe that is starting to change with the money City have spent and the fact that they are getting stronger.
"This might become the big game for United more than Liverpool. "United have had the upper hand in recent years but I'm sure City will see it as a chance to change things. It's such a massive game, a collision of two juggernauts."
Pallister believes the tactical approach of City manager Roberto Mancini will do much to shape the outcome of Sunday's derby. He said: "In the recent past City have come with a negative approach but this season they have been more flamboyant and more open and have some real quality in attack with people like David Silva and Sergio Aguero.
"If they are negative then we could have a first 60 minutes like we had between United and Liverpool at Anfield, but hopefully they will be positive - and then we really will have a cracker on our hands."
Pallister, who won four Premier League titles playing for United between 1989 and 1998, believes his former club's formidable home record in recent seasons could ultimately be the deciding factor in the meeting between the Premier League's two pace-setters.
"You always have to fancy United at Old Trafford and they will take the game to City," he said. "United only dropped two points against West Brom in the league at home last season and they have already beaten Spurs, Arsenal and Chelsea at home this season. "That's an unbelievable record and with the backing of the fans you would make them favourites, but I think a lot depends on how City approach it."