With a legal deadline just two weeks away, negotiations to forge a U.S.-Canada free trade agreement enter their final and most critical phase here Monday with vast differences separating the two nations on make-or-break issues.

High officials of both countries have described as "historic" the idea of a free trade area stretching from the Arctic Circle to the Rio Grande, erasing barriers to the flow of goods, services and investment funds between the world's two largest trading partners.

But agreement is hung up on basic demands by both sides, including Canada's insistence on methods of solving trade disputes outside of U.S. trade laws. The United States is pushing for more open investment opportunities, including an end to barriers to U.S. ownership in the politically sensitive area defined by Canada as cultural industries; for better protection for intellectual property, and for changes in a 20-year-old auto pact that has been a great boon to Canadian manufacturing."Now is the moment of history, the moment of truth," said Canadian Ambassador Allan E. Gotlieb. "We've got some real basic issues to be resolved. It's a very open question whether we'll have anything or not. At this time it is very iffy."

U.S. Trade Representative Clayton K. Yeutter has made similar statements in meetings with business leaders, but added that all negotiations look their worst near the end, when the most contentious issues must be faced.

The success of talks is critical both for Prime Minister Brian Mulroney, who first suggested a free trade agreement to President Reagan at the Shamrock Summit in 1985 and who has made it a cornerstone of his administration, and for Reagan administration efforts to put teeth in the international compact that regulates world trade, the General Agreement on Tariffs and Trade (GATT).

"If you can't do it with the country you are closest to, how are you going to be able to do it with the 94 other nations in the Uruguay Round {of global trade talks to improve GATT}. The implications are very serious if this fails, for the entire GATT round and the whole free trade concept," Gotlieb said in an interview Friday.

Sen. Richard G. Lugar (R-Ind.), former chairman of the Foreign Relations Committee, called the free trade talks "one of the most important hemispheric situations of our time," and added, "If we aren't able to work out an agreement with our closest friends we are in trouble."

Nonetheless, key congressmen, most of whom support the concept of a free trade agreement, are deeply suspicious that Reagan administration trade negotiators will bow to Canadian demands in the interest of reaching an agreement.

Under a special fast-track arrangement for handling trade pacts, which expires Jan. 3, the House and Senate have 90 days to vote the agreement up or down, with no chance of amending it. To meet that timetable, Reagan has to submit the agreement to Congress by midnight Oct.4 -- two weeks from tonight.

Public opinion in Canada is deeply divided and the idea of a free trade pact has turned into a major political issue, raising questions of Canadian nationalism. The opposition parties are strongly and vociferously opposed to the agreement. In addition, Mulroney's popularity has been sinking, and David Peterson, who just won overwhelming reelection as premier of Ontario, Canada's richest province, is firmly opposed to key U.S. positions on investment and the auto pact, although he has not come out squarely against the agreement.

While the provincial premiers don't have the life-or-death hold over a trade agreement that Congress does, their approval is needed to build a political consensus in Canada and for implemention in key areas, including lifting barriers to sales of U.S. wine, beer and liquor and to U.S. sales to their governments.

About $150 billion in goods and services flow between the United States and Canada each year, the largest movement of commerce between any two countries in the world. Almost 80 percent of Canada's exports head south to the United States. While the northward flow of goods is smaller, Canada is the largest foreign purchaser of U.S. products, buying 25 percent of U.S. exports.

A major argument in favor of the pact is that trade between the two countries would increase without barriers, bringing added prosperity to both nations.

With two weeks to go, however, both sides can't even agree on what they have already have settled. U.S. trade officials said they have refused to accept a Canadian document and negotiators failed during a full week of talks to come up with a joint text that sets out areas of agreements and places areas of differences in brackets.

Gotlieb, however, said there is "a vast amount of material agreed on," including an approach that will abolish tariffs between the two countries over a period of time. Although 65 percent of all trade passes tariff-free between the two countries, Canadian tariffs on the rest are about twice as high as U.S. tariffs, hurting American sales.

In addition, Canadian trade officials cited good progress in erasing nontariff barriers, especially setting uniform technical standards for the sale of products in the United States and Canada.

Both sides admit that the talks are stalled on the major aims of both sides. But an agreement on a new way of settling trade disputes outside of current U.S. trade law -- the Mulroney government's major reason for pushing ahead with the free trade pact -- would likely lead to an agreement in most of the other areas. Canadian negotiators indicate they are willing to compromise on other issues in return for a binding, bilateral dispute settlement mechanism.

Canadians view U.S. trade laws, and the ability of Congress to change them to benefit special interests, as harassments that hurt their sales in the United States. In the secret negotiations it has proposed a bilateral dispute-settling mechanism that would be binding on both sides, coupled with a promise to gradually reduce its web of subsidies that help Canadian industry. It is unclear how far the Reagan administration is willing to go in that regard, but key congressional leaders have said they oppose what they see as a circumvention of U.S. trade laws.

But the trade-offs for the United States could be great -- including added investment opportunities and an end to barriers that keep U.S. service industries out of Canada.

"I think it would be good for both our countries. Barriers get in people's way, they slow things down," said Rollie Boreham, head of Baldoor Electric Co. of Fort Smith, Ark., a company that sells about $5 million a year in electric motors to Canada -- one-fourth of his company's total sales.

Baldoor's Canadian sales have dropped because of "all kinds of barriers we have to climb over to do business in Canada." These include "tariffs first, tribunals that set minimum prices, and they change the rules all the time. There are a whole series of barriers, and they get in the way."

Presumably, they would all be erased in a free trade agreement.