In their meeting here this week, President Reagan and Jordan's King Hussein will be grappling with the same close questions raised by last week's swap of Israeli POWs for imprisoned Palestinians: Under what circumstances, and for what purposes, is it sound practice to do business with "terrorists"?

Let it quickly be said that the Israelis officially reject the connection. Arranging by whatever means for the speediest possible return of captured Israeli soldiers is a thing apart. It is an article of faith, a government commitment Israeli fighting men carry into battle. Bringing the Palestine Liberation Organization however indirectly into the Middle East "peace process," which is what Hussein and Reagan will be talking about, involves an altogether different Israeli article of faith.

Indeed, the United States is committed to the Israeli position that the "terrorist" PLO cannot participate in peace talks until it recognizes Israel's right to exist and accepts U.N. resolutions defining the ground rules for any peace effort.

And yet the connection (and the contradiction) are self-evident. The business at hand in the Reagan-Hussein talks turns precisely on the question of who will represent the Palestinians' interests in new negotiations aimed at resolving the future of the Israeli-occupied West Bank and Gaza.

Who else might sit in (Egypt, for example, if the Camp David formula and the terms of the Reagan initiative in 1982 are to be observed) is far from clear. But the degree of association of the PLO, still officially designated by the Arabs as the "sole legitimate representative" of the Palestinians, is the nub of the matter.

There lies the connection with last week's exchange of prisoners. It is more than a debating point. Both Hussein and the Palestinians can logically argue that Israel's strict terms for doing business with "terrorists," when it comes to peace and security, have been progressively whittled away by its unconditional readiness to deal, however circuitously, with the PLO and kindred organizations when it comes to recovering Israeli POWs.

The Israeli government denies it, insisting that last week's deal sets no precedent. The government's increasingly clamorous critics answer that in fact it sets a terrible precedent. Prominent figures long familiar with Israel's professed counter-terrorism stratgegy -- dramatized most forcefully by the celebrated Entebbe hostage rescue -- claim that the exchange has cut the ground out from under the argument that any appeasement is an invitation to terrorism. Actually, last week's deal sets no precedent, only because the precedent had already been firmly set.

Not the least of the costs of the Lebanon invasion was the necessity ultimately imposed upon Israel to do business with the PLO. Even before the invasion of Lebanon, Israel had negotiated a cease-fire across its northern border -- through intermediaries, but of necessity with the PLO. A captured air force pilot and an Israeli civilian were returned to Israel as part of an agreement (arranged indirectly with the PLO) for evacuation of the PLO guerrilla forces from Beirut.

In November 1983, six Israeli soldiers held by the PLO were exchanged for 4,500 "detainees" in an Israeli prison camp in Ansar and 99 "terrorist" convicts from Israeli jails. Half of the convicts were doing life terms, and many were associated with especially notorious and murderous terrorist acts. The main difference this time was that large numbers of convicted terrorists were released to return to their homes in Israeli-occupied territory; in 1983, the hard cases were deported to Algeria.

That the uproar in Israel should be much louder now owes much to the inherent vulnerability of Israel's shaky coalition government. That same shakiness could make Israeli Prime Minister Shimon Peres all the less willing to compound the "terrorist" issue by giving ground on the "Palestinian representation" issue in the peace process -- and also make the Reagan administration even less willing to push. This would make it all the more difficult for King Hussein, who deserves more credit than he generally gets for his efforts to assemble a credible Jordanian-Palestinian negotiating team.

Alternatively, the willingness of Peres to go through with the prisoner swap is read by some diplomats as a sign of strength, reinforcing hopes that yet another small but significant "move forward" will come of the meeting between the president and the king. "It's going to be an interesting week," says one official. He and others do not pretend to know how the prisoner swap will play out politically in Israel.

How it should play out logically is something else. If logic has any part in it, it is hard to escape the conclusion that Israeli resistance to doing business with the PLO has been robbed of a good deal of its force.