Israel disclosed yesterday that it is preparing to free one of its most notorious convicted terrorists, Greek Catholic Archbishop Hilarion Capucci, 55, who was sentenced to 12 years' imprisonment in 1974 after having been caught smuggling guns and explosives from Lebanon to Israel in his official car.

Demands for Capucci's release have turned up regularly in the lists submitted by airplane hijackers, including the Entebbe hijackers, but where threats have failed a personal letter from Pope Paul apparently has succeeded.

Israeli officials made it clear that they are freeing Capucci chiefly to improve relations between the Jewish state and the Vatican. The negotiations were initiated by the government of Prime Minister Menahem Begin, sources say, after the previous Labor Party government had avoided such a move on the ground that it was too risky politically.

The apostolic delegate in Jerusalem, the yellow and white flag of the Vatican flapping from the tender of his car, brought a letter from the Pope to the president of Israel, Ephraim Katzir, late this afternoon requesting clemency for Capucci.

"It is now up to the government of Israel," Archbishop William Carew said, as he left the president's residence. He expressed the hope that Capucci would soon be released.

Israeli sources said that the negotiations for Capucci's release had been worked out ahead of time in Rome and that the presidential granting of clemency for the "gunrunning cleric," as he is called in the Israeli press, could now be assumed. Capucci's release and immediate deportation are expected to take place within the next few days.

The price Israel extracted from the Vatican for Capucci's release was a personal letter from the Pope which, according to officials here, contains some admission of Capucci's guilt and acknowledgement that he had a fair trial. At the very least, sources said, the letter cannot be construed as a denial of his guilt. The appeal is being made on humanitarian grounds.

The understanding with the Vatican, according to Israeli sources, is that Capucci will not be allowed to make propaganda for the Arabs against Israel and that he is to be posted to a place outside the Middle East.

The former Labor government of Yizhak Rabin contemplated making the same deal in February, but was afraid to do so lest the then opposition party of Begin make an election issue out of the release of a convicted terrorist, former director general of the foreign office, Shlomoa Avineri, told reporters this week.

It is possible that Capucci will be taken out of the country before the announcement of his release is made, but final plans for his deportation have not yet been completed. Capucci is said to have lost weight due to hunger strikes and is taking tranquilizers.

Israelis say that the question of Capucci's imprisonment had come up again and again in their dealings with the Vatican and that they hoped his release would not only put Israel's relations with the Vatican on a more normal footing, but also create goodwill throughout the Catholic world.

The Vatican has never formally recognized the state of Israel - a fact that has irked the israelis for 30 years. The apostolic delegacy has refused to comment at all on the affair but, privately, Roman Catholic sources here have said that the move was clearly designed to nudged the Vatican closer toward de facto, if not de jure, recognition.

One might ask what the Vatican gets out of Capucci's release?

"The church would rather not see its archbishop behind bars anywhere in the world if they can help it," one Catholic source said here.

The Syrian-born Capucci is reported to have said that he would rather stay in jail than be deported from the area but that he was a soldier in the service of the Vatican and would do what he was told.

There seems to be very little question that Capucci was in fact smuggling arms for the Palestinian Liberation Organization and at least one Israeli is thought to have died as a result. The PLO publicly denies hit guilt and has declared him a martyr, but privately many PLO members do not bother to deny his guilt and deplore his carelessness in getting caught.

The Greek Catholic Church is a sect that broke away from the Greek Orthodox Church in the 1860s to recognize the authority of the Pope in Rome. Theologically, however, they remain very similar to Greek Orthodoxy and their services are basically Greek rather than Roman. The Greek Orthodox Church formally split with Rome in 1054.

Capucci has been held in the maximum security prison at Ramleh since his conviction, according to diplomatic sources who have visited him, and has been accorded better treatment than the average prisoner.

Perhaps the most notorious inmate of Ramleh prison is Kozo Okamoto, the Japanese Red Army terrorist who, with his companions, killed more than a score of people in the Lod airport massacre of 1972.