The Israeli Cabinet yesterday described Egyptian President Anwar Sadat's latest Middle East peace proposal as "completely unacceptable," but decided to send Foreign Minister Moshe Dayan to London later this month to resume peace talks anyway.

Prime Minister Menachem Begin, following the five-hour Cabinet session, said that Sadat's peace plan, which calls for Israeli withdrawal from the West Bank and the Gaza Strip, "cannot by its nature lead to the establishment of peace."

Cabinet Secretary Aryeh Naor said that the ministers deliberately avoided a formal rejection of the Sadat plan and decided instead to brand it as "unacceptable" in order to assure that peace negotiations broken off in January could resume in London. Naor said the Cabinet hoped that the foreign ministers conference could start on a "positive mood."

Asked how branding the Sadat plan in advance as unacceptable would lead to positive attitudes, Naor said, "Rejecting it would preclude negotiations. Calling it unacceptable means that we are ready to discuss anything."

Naor said the Sadat proposal "is unacceptable not only from the point of view of the government, but of all Israelis - except a Communist or two."

"Who is goint to suggest that we give up East Jerusalem, give up the settlements, go back to the 1948 lines, jet the Arabs establish an independent state, let the refugees back in," Naor said.

Naor said that the decision to send Dayan to London was unanimous, but that no Cabinet minister had expressed support for any aspect of the Sadat plan, although it appeared to contain a softening in some areas of Egypt's position.

Meanwhile, in Vienna, opposition Labor Party leader Shimon Peres met with Sadat for two hours in the morning, and again for about 90 minutes in the afternoon to discuss Middle East peace prospects informally.

"We both presented our views and had very constructive talks," Sadat said after the morning session. "It was a very happy gathering."

Peres, who also made a statement, stressed that he was in Vienna as the leader of the Israeli Labor Party, and not as a representative of the Israeli government.

"The Israeli Labor Party recognizes that there is a problem of the Palestinians," he said. "We believe that this problem should be solved in a fair manner, acceptable to the Palestinians. The best way to reach a settlement is to continue the direct negotiations between Israel and Egypt."

Peres' meeting with Sadat, arranged by Austrian Chancellor Bruno Kreisky, was a topic of conversation at yesterday's Cabinet meeting, Naor confirmed. He would not detail what was said, other than to say that several ministers expressed criticism and that one said, "Mr. Peres is trying to get to power on Sadat's shoulders."

Since Sadat gave his proposal to Vice President Walter Mondale in Alexandria last week, high-ranking Israeli leaders have made unofficial attempts to dispel the notion that the Sadat plan could ever be acceptable.

But the officials have conceded privately that they feel Sadat has put Israel in a diplomatic position from which its only option is to send Dayan to London.

Sadat's proposals, submitted July 3, include an apparent readiness to agree to demilitarization of the West Bank, ommission of the Palestine Liberation Organization as a participant in establishing a new government, ommission of mention of a Palestinian state, and an apparent readiness to accept limited Israeli presence in the West Bank for a limited period of time.

Those understandings, Israeli officials said, have been transmitted privately by the Egyptians in a series of communications, and in statements by the Egyptian president.

Under Sadat's plan, Israel would withdraw its military occupying forces and Jewish settlements from the West Bank and Gaza Strip,and Jordan and Egypt would administer the two areas - respectively, while the Palestinian Arabs would determine their own future during a five-year transitional period.

Naor said that Israeli delegation to London, in addition to Dayan, will be led by Israeli Attorney General Ariel Barak and foreign ministry legal adviser Meir Rosenne. Egypt will be represented by Foreign Minister Mohammed Iphraim Kamel and his aides, and the United States will send Secretary of State Cyrus Vance and top State Department officials.

Naor said the Cabinet instructed Dayan to resume the work of the Egyptian-Israeli Political committee, whose talks broke off six months ago, and to work toward "the promotion of the peacemaking process aiming at the conclusion of peace."

The Cabine's alternative to those instructions would have been to direct Dayan to focus on the renewal of efforts to agree on a declaration of principles.

Cabinet sources said that the government's attitude toward a declaration of principles has not changed since Dayan's visit to Washington in April, when the foreign minister expressed strong doubts that such a peacemaking strategy would work.

"We think that from the technical point of view, it is better to start with relevant, concrete proposals, but if they (the Egyptians) think otherwise, well, it is up to them to suggest it," Naor said.

As of now, officials said, both Egypt and Israel will present their peace plans and begin discussions on the basis of what already has been submitted.

Israel's proposal, submitted earlier, would give Palestinian Arabs in the occupied areas limited self-rule during a five-year transitional period, after which Israel would assess the prospects for granting further political self-expression. During that time, Israel would maintain an occupying military force in the West Bank and Gaza and would keep settlements there.

Naor said the government "hopes they (the Egyptians) will be ready to discuss issues beyond Sadat's plan," such as negotiating for a formal peace treaty, which is not mentioned specifically in the Egyptian plan.