The Reagan administration reacted sharply yesterday to reports that Israel is going ahead with a decision to build more Jewish settlements on the Israeli-occupied West Bank. The State Department called the action "most unwelcome," and the White House said it was "not helpful" to the Middle East peace process.

"We cannot understand why, at a time when we are actively seeking broader participation in the peace process, Israel persists in a pattern of activity which erodes the confidence of all . . . , " said State Department spokesman Alan Romberg, referring to U.S. efforts to win the backing of Jordan and other moderate Arab nations for President Reagan's peace initiative in the Middle East.

When he made his peace proposals on Sept. 1, Reagan called for a freeze on Israeli settlement in the occupied West Bank, where more than 20,000 Jews now live in more than 100 such settlements among 800,000 Palestinians. Reagan proposed that Palestinians in the West Bank and Gaza be granted self-rule in association with Jordan.

But the Israeli Cabinet acted later in September to approve establishment of eight new settlements on the West Bank. Housing Minister David Levy said in Israel Wednesday that five of the eight would be set up soon.

Reacting to reports of Levy's statement, State Department spokesman Romberg said yesterday that this determination to continue expansion of Israeli settlements on the West Bank "raises questions about Israel's willingness to abide by the promise of U.N. Security Council Resolution 242 that territory will be exchanged for true peace."

Israeli diplomats said they were surprised at the harsh language. One senior Israeli diplomat termed the U.S. public criticism "a mistake."

"It will become a self-fulfilling prophecy," he said. "If you call something an obstacle, it becomes an obstacle."

Israeli Ambassador Moshe Arens met yesterday afternoon with Secretary of State George P. Shultz in a session State Department officials said Arens had requested. After the meeting Arens said it had focused primarily on Egyptian-Israeli relations and on the issue of withdrawal of foreign forces from Lebanon.

But the Israeli ambassador added that he had brought up the settlements statement briefly because Israel had made no formal announcement of new settlements.

The latest public confrontation over settlements comes only a day after the White House announced that Reagan will be meeting with Israeli Prime Minister Menachem Begin on Nov. 19 during a private trip by Begin to the United States. It also comes at a time when senior U.S. officials have made it clear that the next step in the Reagan peace initiative rests not with Israel but with the Arabs.

State Department officials privately said any new settlements activity was seen as a direct challenge to Reagan. One senior State Department official said earlier in the week that "the president is going to have to say something about the settlements, and soon."

"If we don't get cooperation on this issue, we won't be able to get cooperation on anything, from either side," another official said yesterday. "It is of major psychological importance to the Arabs, and it is of major importance to the president's credibility.

"We don't understand why they defiantly reject the president's request," the official said. "As a 'full partner and strategic ally,' they should listen to the president."

The official called the settlements issue a "litmus test" of U.S. influence and intentions in the eyes of the Arabs, who now are in the position of deciding whether Jordan's King Hussein will have the support he apparently feels he needs to go to the bargaining table with Israel and the United States.

"It is a matter of perception on the part of the Arabs," another official said. "They see it as supporting their view that Israel's real intention is annexation of the West Bank.

"We are serious about this. It is not a question of pick on Israel for this or that," the official said.

A high-level State Department official said earlier in the week that the "ball is in the Arab court" on the negotiations issue, with no clear indication as yet whether Hussein will agree to talk. In the meantime, he said, the United States will continue to talk with Israel on the broader peace process, but that no substantive steps are likely.

While U.S. officials have put an optimistic gloss on the Arab response so far to the Reagan initiative, they also have been openly critical of Arab unwillingness to recognize Israel explicitly.