The rescue operation involved the Ramu NiCo vessel MV Carrie which was ferrying a delegation from the Chinese embassy, including consul Gao Yongxue, from Basamuk to Madang.
Ferry captain Charlie Buai said they were alerted by passengers in two other banana boats.
"While on route from Basamuk to Madang, two banana boats signaled to us that a dinghy had sunk and the survivors were still in the water, while a couple were loaded onto their boat," Buai said.
Buai said Yongxue, who is also the president of Ramu Nico (MCC), immediately directed that the ferry change course and travel to the area where the vessel had sunk.
He said Madang did not have a search-and-rescue vessel.
"We had to use our vessel Carrie to conduct the search and rescue on the instruction of Gao who was also on the vessel," Buai said.
"We managed to fetch all the survivors on to the Carrie including the dead woman and her daughter," Buai said.
"A mother and an infant with another child were clinging on to a plastic item and floating on the front part of the dinghy when we found them."
He said a child was also rescued about 50m from the rest of the survivors floating on a new basketball he had bought in town earlier that day.
Madang rural police commander Anton Michael and officers were at the jetty in Madang to take the 17 to the Modilon General Hospital.
The skipper of the dinghy and its owner were taken in by police for questioning.
Buai said 20 people were in dinghy including three children when it sank near Tabalip Point. The dinghy is owned by a person from Panitibun Island near Madang town and was travelling to the Saidor station. It is a seven-metre boat with a 60 horse-power engine.
A senior police officer said the Madang provincial administration should have set up the Small Craft Registration Authority to conduct more awareness on sea travel, and ensure all small crafts carried safety equipment in the waters of Madang.