For the first time since a 1973 coup that transformed Uruguay into South America's most totalitarian police state, the military government slowly has begun to loosen its grip on what was once the continent's most advanced social democracy.

A sharp decrease in the number of political arrests, an end to officially sancitioned torture and a reduction in the number of political prisoners from 5,000 two years ago to a current 1,600 have led to improved relations with the United States, which has again begun selling small quantities of nonlethal military equipment of Uruguay. The sales are part of a "carrot and stick" approach designed to speed improvements in human rights here.

Despite a continuing prohibition against all forms of "political activity," Uruguay's two traditional political parties, the Blancos and the Colorados, have been allowed in recent months to hold some small gatherings.

Although strikes remain forbidden, the government unofficially gave noncommunist labor unions permission to reorganize last year. In a development that perplexed diplomatic observers, young Navy officers recently have begun meeting with leaders of the country's once powerful communist unions, urging them to reorganize as well.

These meetings have surprised Western diplomats because Uruguay's military rulers say they must remain in power for now to guard against communist subversion -- seven years after they took control of the government to crush the Tupamaro guerrilla movement, which never had a Communist Party support.

Uruguay's major newspapers, which remain the most timid and controlled in South America, also have begun to test the limits on criticizing the government. Earlier this month, the daily El Dia organized a symposium, which it then covered in detail, of professors and political leaders who were asked to discuss Uruguay's democratic traditions.

Uruguay's military leaders also still seem to be committed to a timetable they announced two years ago to hold an election next year on a new constitution they are drawing up as a prelude to some so far unspecified form of civilian elections in 1981.

Despite a general reduction in the level of police surveillance and terror, the government has yet to change any of the Draconian national security laws that were approved in 1972 by the country's last elected Congress to deal with the Tupamaro urban guerrillas. These laws were then augmented when the military closed the Congress and took control in 1973.

The statutes prohibit gatherings of more than five persons for any reason -- including soccer games -- without police permission, prohibit all political activity, make it a crime to criticize the government or the military, ban strikes, and provide for a parallel military judicial system to deal with "subversives."

While the secret police have reduced activity within Uruguay, they have not stopped kidnaping Uruguayans living outside the country. Last July, two Uruguayans living the Porto Alegre, Brazil, were abducted by Uruguayan police officers an incident that has become a major source or irritation between Uruguay and its much larger neighbor to the north.

Nor has the government lifted a ban on about 1,000 politicians who, having figured in elections of 1967 and 1971, are prohibited from all forms of public life. Their names may not be mentioned in the press or on radio and television stations here.

This proscription was taken to what even government supporters agree was a ridiculous level in August, when a bull belonging to Wilson Ferreira Aldunate, a Blanco Party presidential candidate in 1971 who is living in exile in London, was removed from a cattle exhibition because of a small sign all the bulls were required to display with the names of their owners.

Pulic employes, who comprise about 25 percent of the country's small working population, must obtain security clearances even for jobs as streetcleaners. This and a law that allows public employes to be dismissed without cause effectively repress political activity and dissent, according to political observers here.

Nonetheless, there has been a noticeable increase during the past year in the willingness of average Uruguayans, including public employes, to complain about the current government.

Almost no one here has a good word to say about the government's economic policies, which have achieved full employment and a growth rate this year that will probably come close to 9 percent, but which have at the same time allowed inflation to rise to an annual rate of 65 percent and created beef shortages in a country that has four cows for each of its 2.5 million people.

Average Uruguayans also seem to be less impressed with the government's justification for its current existence: stopping communism and terrorist subversion.

While the Tupamaros frightened the country during the first years of the decade, it has been at least six years since they were in a position to kidnap or kill. Hardly anyone here thinks there are enough communists in the country to make much of a difference -- except for those locked in Libertad, the country's prison for political prisoners.

"We're tired of this government," said one government employe. "They have robbed us of our liberty in the name of peace and order. The dead have peace and order but they have nothing to look forward to.

"You know, for the past six years we have been dead. Only now are we beginning to live a little. Just a little, understand?"