An envoy of Palestine Liberation Organization Chairman Yasser Arafat, saying that the PLO was responding mistakenly to President Reagan's Middle East plan, has urged the organization to recognize Israel so that it obtains U.S. recognition and can enter peace negotiations.

Issam Sartawi, Arafat's representative in Western Europe and a prominent PLO moderate, criticized the PLO leadership for seeking to work jointly with Jordan's King Hussein in reacting to Reagan's proposal to create a Palestinian entity linked to Jordan on land that is now occupied by Israel.

"The great mistake that the PLO is making at this moment is not sending the ball back to Reagan and saying we have recognized Israel and, therefore, we have to be represented on our own in negotiations ," Sartawi said in a recent interview here. "We should either recognize Israel and become a recognized entity in the conflict or pass on the mantle of representation to Hussein."

Going beyond previous Palestinian statements, Sartawi said that the PLO ultimately would settle for a state in the occupied West Bank and Gaza Strip and would give up any designs on the rest of Israel's territory.

He claimed also to speak for Arafat on this point, and he is known to be close to the PLO chairman. In the past, however, Sartawi's conciliatory statements have not been followed by public PLO endorsements.

Speaking for two hours in his office here, Sartawi spelled out a vision of a future with Palestinians, Israelis and Jordanians living together in peace in what perhaps is the strongest such description ever given by a PLO leader.

"A two-state solution nationhood for both Israel and a Palestinian state must be sought. However, even that is not the ultimate answer," Sartawi said. "I personally cannot see why there should not be a formula whereby the states of Palestine, Jordan and Israel would freely join into a confederation."

The Palestine National Council, or parliament-in-exile, meets Feb. 14 to consider PLO strategy at a time when radical factions are condemning Arafat for being too open toward Reagan's plan and for negotiating with Jordan.

Partly to protect himself, Sartawi said Arafat and the rest of the PLO effectively had recognized Israel when the last national council meeting, in April 1981, formally endorsed the late Soviet leader Leonid Brezhnev's call for ensuring the security of all states in the area, including Israel.

"It the initiative is binding to people from the PLO chairman to the last Palestinian. That is why I state formally, officially, publicly with no reservations that Chairman Arafat is bound to recognize the state of Israel," Sartawi said.

Asked specifically if he, Sartawi, personally and explicitly recognized Israel, the PLO official responded, "I have recognized Israel within the 1967 borders"--the borders prevailing before the 1967 Middle East war.

Sartawi warned that "time is running out" for the Palestinian people and for the PLO because of expanding Israeli settlements in the occupied territories.

"Unless we, the PLO leadership, fulfill our full responsibility to our people, then we are going to fall, and our people are going to bypass us and find the alternative that will enable them to achieve some rights," he said.

"Part of the tragic situation in Lebanon is certainly the fault of the Israelis. Part of it is the Americans' fault. But certainly part of it was also our fault," he said. "And, as usual, leadership faults are paid for with blood. Our people paid for our faults with their blood. If we cannot show our people some tangible relief from their misery, then the question will arise: how long will our people accept us as leaders?"