The Malbim, commenting on the second of the two versescommenting on the second of the two verses, explains that שבי refers to someone who is already definitively a captive, i.e. it has already been decided that they will be taken and kept as a captive/slave. שביה, on the other hand, refers to those who are still under consideration whether they will be taken as captives.
Thus, the Midrash understands ושבית שביו - you shall take their captives - to include even Canaanite captives, who normally we must not let live, we can take as captives. The Midrash understands the verse to say that we can take those captives who were captives of the nation we defeated - those who were already decidedly captives before the war, which could include Canaanim. Even them we can take as potential captives. The next verse is referring to the camp of prisoners that have just been captured and are being considered for whether or not they should be kept.