With a bittersweet mixture of nostalgic sadness and celebration of peace, Israel's Army today completed a pullback from two-thirds of the Sinai Peninsula, where 2,255 of its soldiers fell in three decades of struggle with Egypt.

"We didn't retreat. We left in peace," proclaimed a huge sign overlooking a flag-bedecked parade ground as scores of Patton tanks rumbled onto flatbed carriers for the long northward trek across the desert.

But its acts today, Israel put into motion the long-awaited process of normalizing formal displomatic relations with Egypt, its most powerful adversary in four wars. While another, symbolie withdrawal ceremony will be held here Friday, virtually all of Israel's Sinai Army command had moved as of tonight behind a line stretching from El Arish in the north to Ras Muhammed in the south. The remaining third of the Sinai is to be returned to Egypt in two years.

In yielding an irregularly shaped, 7,000-square-mile section of the desert -- the largest portion to be returned to Egypt since the Camp David peace treaty was signed last year -- Israel gave up its most valuable holding in the Sinai, surrendering much of the area it has relied upon to defend its southern border.

Among the military sacrifices were the all-important Giddi, and Mitla passes through the western mountain range, the only accesses to the plains where many decisive tank battles have been fought.

As if offering tangible evidence that the Sinai withdrawal was not in vain, the Israeli government announced tonight that it had located a site for its embassy in Cairo -- the first in an Arab state -- which is to start functioning temporarily in hotel rooms when relations formally begin on Sunday.

However, Egypt has yet to send representatives to Israel to look for its embassy site, an omission some officials here interpret as calculated hesitation in anticipation of a barrage of criticism from hard-time Arab states on Sunday.

Egypt has also delayed direct commercial airline flights between tel Aviv and Cairo, which were to have begun on Sunday.

The Israeli Army left behind barely a trace of the once sprawling Refidim military base, the biggest in the Sinai. Whole buildings were dismantled and carted away and those that could not be moved were razed, excluding a few the Israelis found here when they captured the Sinai in the 1967 Six-Day War.

Those included a movie theater and a mosque, which the Israelis had converted to a synagogue and then reconverted to a Moslem house of worship just before the withdrawal.

As the last of the lumbering tank carries moved north, Refidim seemed almost to revert to natural desert. It will legally resume its Arab name of Bir Gafgafa at the end of the week.

Today's withdrawal ceremoney was an exclusively Israeli affair, with hundreds of national flags snapping in a brisk winter wind as most of the Army commanders who fought in bloody Sinai campaigns gathered to say farewell to the desert.

Military might blended easily with paeans to peace. Squat, menancing-looking tanks crisscrossed the parade ground in a noisy ballet of armor. A formation of war planes screamed overhead and rifle-carrying tank crewmen marched in parades.

The parade ground resounded with the strains of "Lu Yehi" (May it Be), a haunting ballad of war and peace, suffering and hope, that captured Israelis' hearts after the costly 1973 war.

The soldiers listened to a reading of a mournful Hebrew poem, "Farewell to Sinai," which lamented the loss of the desert's beauty and ruggedness.

Israeli Army chief of staff Gen. Rafael Eitan, in his farewell address to the Sinai southern command, said: "The peace we've dreamed of brought us to give up the Sinai in the hope that wars with Egypt in our generation will end . . . You fought here with a mightly hand."

Maj. Gen. Daniel Shomron, noting a "residue of hatred" left by the wars, asked rhetorically, "Will this bring an end to the conflict and build peace?"