A novel method for simultaneously forming and filling and decorating carbon nanotubes with palladium nanoparticles is disclosed. Synthesis involves preparing a palladium chloride (PdCl.sub.2) solution in a container, having two graphite electrodes, then immersing the graphite electrode assembly, into the PdCl.sub.2 solution; connecting the graphite electrodes to a direct current power supply; bringing the electrodes into contact with each other to strike an arc; separating the electrodes to sustain the arc inside the solution; putting the container with electrode assembly in a water-cooled bath; and collecting Pd-nanoparticles encapsulated in carbon nanotubes and carbon nanotubes decorated with Pd-nanoparticles. The temperature at the site of the arc-discharge is greater than 3000.degree. C. At these temperatures, the palladium is ionized into nanoparticles and the graphite electrodes generate layers of graphene (carbon), which roll away from the anode and encapsulate or entrap the Pd-nanoparticles. The unique nanotube structures have significant commercial potential as gas sensors or as a means for hydrogen storage.