FORTUNE — Many view the resource-rich South China Sea as a likely flashpoint in East Asia; one that could ignite both localized military conflicts and drag in the United States. And for good reason.

The vast expanse of water contains abundant fisheries, immense untapped oil and natural gas deposits, and small uninhabited islands or rocks contested by China, Vietnam, the Philippines, Malaysia, and Brunei.

Things got ugly in early May, when dozens of Chinese official ships confronted Vietnamese coast guard patrol boats approaching a giant oil rig deployed by Chinese offshore oil company China National Offshore Oil Corp (CNOOC) in waters claimed by both China and Vietnam. In the ensuing melee, a Chinese ship rammed a Vietnamese ship, injuring several Vietnamese crew members. Another Chinese ship doused a Vietnamese ship with a water cannon.

No shot was fired during the incident. However, the confrontation foreshadows potentially more dangerous escalations to come, particularly between China and Vietnam.

Based on international law, Chinese claims in the southern parts of the South China Sea (the Spratlys) are much weaker because these parts are farther away from China. China effectively controls only five “features” of this region (unsubmerged small reefs), while Vietnam occupies close to 30.

However, Chinese claims in the northern parts of the South China Sea are stronger because of China’s effective control of the Paracels, a group of islands that fell into Chinese hands after its navy routed the then-South Vietnamese navy in a brief but decisive battle in 1974.

Despite its military defeat, Vietnam has never conceded the sovereignty of the Paracels while China firmly believes it rightfully owns them. As a result of these conflicting claims and the fact that the exclusive economic zones (EEZ) of China and Vietnam overlap each other in this area, neither country is willing to back down. The site of the latest maritime confrontation is 120 miles from Vietnamese coasts but sits within the 200-mile EEZ of the Chinese-occupied Paracels.

Until now, confrontations near the waters of the Paracels were limited to China’s harassment of seismic surveying activities conducted by Vietnam. While such incidents could lead to escalation, seismic surveying activities themselves do not create hard facts on the sea floor, limiting the potential for conflict.

In the latest — and far more dangerous — confrontation, China’s success in building an indigenously developed deep-sea oil rig, CNOOC’s HD-981, which cost roughly $800 million, allows the Chinese state-owned company to drill in areas it previously had no capacity to exploit. The rationale for CNOOC’s deployment of HD-981 in the contested waters of the Paracels remains unclear, but it is clear that this decision has received top-level government endorsement.

This can be seen in the fact that Beijing, which sent more than 80 ships to protect HD-981, must have anticipated strong reactions from Hanoi. It is also reasonable to assume that Beijing has made contingency plans for further conflict.

It now all comes down to Vietnam’s response.

Unlike the Philippines, the Vietnamese government has devoted considerable resources to defy China’s maritime claims. In recent years, Hanoi has purchased six highly capable Russian Kilo-class submarines (three have been delivered) and several squadrons of SUK-30MK fighter jets, which specialize in attacking ships. Such investments are clearly a plan in preparation for conflict with China in the South China Sea. Of course, the much smaller Vietnamese navy would be no match against the People’s Liberation Army Navy (which has similar Russian military hardware). But in a shooting fight, Vietnam could make China pay dearly.

Should an air-naval battle break out between China and Vietnam near the Paracels, the U.S. would face a quandary. Officially, Washington takes no sides in the disputes over the ownership of the contested islands. But the U.S. is more sympathetic to those opposing Chinese claims. Providing military aid to Vietnam, short of direct intervention, may be of limited value since the disparity in the forces between Vietnam and China is simply too large. Yet allowing China to bully a smaller neighbor into submission not only violates American principles but also sets a troubling precedent.

So, for now, the most likely short-term solution will be rooted in diplomacy. Beijing and Hanoi must be busy talking to seek a face-saving way out. China will pressure Vietnam to give up its claims and may dangle some minor concessions as enticements (such as minority ownership in the oil fields being explored). At the same time, Vietnamese friends in the Association of Southeast Asian Nations and the United States will be rooting for Hanoi to stand firm.

It is too soon to tell whether such delicate talks will calm the stormy waters near the Paracels. The most sensible thing to do is to have a 50-50 split of ownership between China and Vietnam in this particular oil field.

But nations — like people — do not always do sensible things.

Minxin Pei is the Tom and Margot Pritzker ’72 Professor of Government and a non-resident senior fellow at the German Marshall Fund of the United States