Indian Prime Minister Manmohan Singh says lack of trust is the main obstacle to improved relations with Pakistan.
Mr Singh told a rare news conference in Delhi that he was trying to narrow the gap and that India was willing to discuss "all outstanding issues".
Ties have been strained since Pakistan-based militants attacked Mumbai in 2008, killing more than 160 people.
Pakistan's foreign ministry told the BBC that it hoped Mr Singh's comments were a positive development.
It said a mutual trust deficit did exist and Mr Singh's comments underlined the importance of bridging the deficit and solving long-standing disputes. A decades-long conflict over the Himalayan territory of Kashmir lies at the heart of the neighbours' mistrust.
Earlier this month India and Pakistan agreed to hold more peace talks after a meeting between Mr Singh and Pakistani Prime Minister Yousuf Raza Gilani.
The countries' foreign ministers are to meet in July after an invitation from Islamabad.
Mr Singh made his remarks at a rare news conference - his first since his government was re-elected last year and one of only a few he has given since coming to power in 2004.
"India cannot realise its full development potential unless we have the best possible relations with our neighbours, and Pakistan happens to be the largest neighbour of ours," he told reporters in the Indian capital.
"The trust gap is the biggest problem."
Mr Singh said he was doing his best to bridge that gap. At the same time, he added, he would not surrender India's vital national interest.
He said he was hopeful that the foreign minister-level talks in July could move the stalled peace process forward.
"This will be the first major effort to deal with the underlying cause that is the lack of trust between our two nations."
Talks formally resumed earlier this year but ended with little more than an agreement to meet again.
The two countries' peace process broke down after the 2008 Mumbai (Bombay) attacks.
Delhi has publicly complained that Islamabad has done little to crack down on elements and groups in Pakistan who planned and executed the attack.
Mr Singh described his government's record in the 12 months since re-election as one of "reasonable achievement".
He condemned a recent rise in attacks by Maoist rebels and conceded that inflation, especially of food prices, "continues to be a matter of deep concern".
But he pointed to progress on legislation to reserve a third of seats in parliament for women and to make education compulsory.
The prime minister, who is 77 and had heart surgery last year, spent some of the 90-minute news conference answering questions about his leadership.
The BBC's Sanjoy Majumder in Delhi says a section of his Congress party has been putting pressure on Rahul Gandhi, the latest member of India's influential Nehru-Gandhi dynasty, to step up and take charge.
Mr Singh said that, while he had no immediate plans to retire, he would be happy to step down in favour of a younger leader if his party asked him to.
"I have been given this job and it is incomplete so my question to retire cannot be raised.
"I sometimes feel that younger people should take over. As and when the Congress party takes [a] judgement I will be very happy to make [a] place."