West German efforts to break the back of its terrorist gangs were dealt a sharp setback yesterday when the Yugoslav government decided to free four of West Germany's most-wanted terrorist suspects who had been held in Yugoslav jails since May.

The Yugoslavs acted after repeated refusals by German courts and the Bonn government to extradite to Yugoslavia several Crostian extremists who had been held in West Germany.

Belgrade has sought extradition of alleged Crostian separatists, saying they were involved in a series of extremist attacks on Yugoslav institutions and officials in West Germany and elsewhere, including the assassination of a Yugoslav vice counsel in Frankfurt in 1976.

The four alleged terrorists - Brigitte Mohnhaupt, Rolf Clemens Wagner, Sieglinde Hofmann and Peter Juergen Boock - are all on the list of the 20 most wanted by Bonn. They are wanted in connection with the slayings in 1977 of the chief federal prosecutor, a prominent bank president and a leading industrialist - three killings that sent shock waves through much of the Western world.

It was unclear where the suspects were headed. They reportedly were flown yesterday to a country of their choosing after a Belgrade court ruled that there was "insufficient evidence" to extradite them.

Yugoslav legal sources in Belgrade said Algeria, Iraq and Libya expressed a willingness to receive them. Algeria seems to be the most likely haven, since the Algerian ambassador to Belgrade is known to have had at least two meetings with the Yugoslav minister of justice in the last month.

The Algerian ambassador has denied to West German colleagues, however, that the meetings were connected with the terrorist suspects, and an ambassy spokesman has formally denied reports that Algeria will receive the four.

Reaction in West Germany to news of the suspects' release was swift. A Justice Ministry spokesman said the Bonn government "views the Yugoslav action as a step backward in the international fight against terrorism." A spokesman for the Free Democratic Party, a member of the ruling Bonn coalition government, described it "as a heavy blow against those struggling to defeat world terrorism."

Although Bonn officials formally expressed surprise at Belgrade's action, it had been clear for weeks that move as it became increasingly more Yugoslavia was moving toward such a irate over West German actions involving the Croatians.

Last week, a major Yugoslav weekly magazine pointed out that the four Germans had already served their sentences for illegal entry into Yugoslavia and there was no further evidence of crimes committed in Yugoslavia and there was no further evidence of crimes committed in Yugoslavia or other evidence to hold them much longer.

The four suspects were captured in a dramatic raid in the Yugoslav city of Zagreb after a fifth suspect terrorist was arrested at Orly airport in France as he was about to board a plane for Zagreb. This provided police with leads on where the other suspects were.

When the Zagreb arrests were made, they were hailed as a great success for international cooperation - including the first such act by a communist country - in the fight against terrorism.

[TEXT OMITTED FROM SOURCE]ever, that self-interest on both sides played a major part since Yugoslavia demanded extradition of eight Croatians in Germany who had been in and out of West Germany jails at various times.

Both sides, however, continued to deny that there was any linkage between the two cases.

The situation grew heated in August when West German courts ruled that three of the Croatians sought by Belgrade could not be extradited because of insufficient evidence against them. West Germany has extremely tight extradition laws. The court decision, while viewed as courageous in some quarters because it was obvious that the West German terrorists in Yugoslav jails were also at stake, immediately provoked charges from Belgrade that West Germany was practicing a double standard regarding terrorists.

Yugoslav officials consider the Croatians as terrorists while Yugoslav exiles see them as freedom fighters against the communist government.

Matters grew worse in September when the Bonn government decided not to extradite the man the Yugoslavs wanted most, Croatian resistance leader Stjepan Bilandzic. This decision, made on the grounds that there were legal proceedings in Germany against Bilandzic for various illegal activities including alleged gun smuggling to Yugoslavia, outraged Belgrade because a court in Cologne previously had ruled that there was enough evidence from Yugoslavia to extradite him.

The Cologne court upheld evidence from Belgrade that Bilandzic was the leader of a terrorist organization, had helped send terrorists to Yugoslavia and was involved in the attempted murder of a Yugoslav diplomat in Duesseldorf in 1976.

Aside from the jurididial dispute with Belgrade, Bonn has also been privately worried about terrorist reprisals inside Germany from many Croatian exiles living here if the Croat suspects are sent back to Yugoslavia.

In mid-June four other German terrorists suspects were arrested by West German police in Bulgaria and quickly returned to West Germany with Bulgarian approval.

This was also hailed as a sign of communist cooperation and it was even suggested in some quarters that the Soviets had tacitly told West German leaders that they had put out the word to cooperate with Bonn.

Although Bonn officials emphatically deny it, sources close to the Bulgarian episode say what really happened is that in return for the quick return of the captured terrorists, Bonn security forces allowed a group of Bulgarians who had been under surveillance for espionage in West Germany to return quietly to Bulgaria.

An authoritative statement published in the Yugoslav press yesterday accused West Germany to tolerating anti-Yugoslav organizations and subversive activity. It said Bonn's refusal to extradite Bilandzic "was rightly understood in our country as a lack of political goodwill to implement the [1975] agreement on extradition and a deviation from cooperation between the two countries in suppressing international terrorism."

The statement said Yugoslavia has never allowed itself to be used as a base for terrorist activity against other countries. It expressed the hope that the affair will not damage relations between West Germany and Yugoslavia - but Western diplomats in Belgrade believe there is little doubt that it will, at least in the short run.