Several miles east of here, halfway down the steep mountain ridge that descends to the flat farmlands of the Jordan Valley, water gurgles from beneath the arid ground.

The spring water flows into an open, concrete canal that was built by the British in 1936. Constructed along the route of a natural riverbed known as Wadi Faraa, the canal carries the water to collection points where it is pumped into the irrigation systems of the Jordan Valley farms.

Six years ago, a number of Arab landowners in the Israeli-occupied area proposed that the aging canal be replaced by an underground pipe. It would be a multimillion-dollar project, but the landowners argued that the eventual savings from increased water conservation, and the elimination of diesel-powered pumping stations because of the spring's natural pressure conveyed through the pipe, would justify the investment. It would help make the Jordan Valley even more productive.

The idea was intriguing enough to win initial backing for a feasibility study to be commissioned by a private agency that funnels U.S. aid to areas occupied by Israel. On Oct. 29, 1979, the project was rejected, without explanation, by Israeli occupation authorities.

The Wadi Faraa Irrigation Project is one of dozens of such proposals that Israeli authorities have turned down over the years with little or no explanation. Now, however, Israel is under increasing pressure to loosen restrictions on independent Arab economic development in the West Bank and Gaza Strip, sharpening domestic debate over their future.

It is referred to here as the "quality of life" issue, a term that Secretary of State George P. Shultz introduced into the lexicon of the Arab-Israeli conflict last year.

Shultz dispatched a team of State Department officials here to see how the relatively meager amount of U.S. aid that is provided to the private agencies in the West Bank and Gaza could be put to better use. The Reagan administration reportedly was quietly urging the Israeli government to grant the Palestinians who live under its occupation more economic independence.

As Israel's new national unity government has shown the first tentative signs of responsiveness, the "quality of life" argument has grown sharper. It has spawned two rival groups in the United States and has exposed anew the deep divisions in the Israeli government over policy toward the West Bank.

The debate is less economic than political. Few in Israel would argue against an effort to continue the dramatic rise in the overall standard of living of individuals in the West Bank and Gaza Strip that has occurred since the Israeli occupation of the territories in 1967. But if "quality of life" also means less Arab economic dependence on Israel -- through new West Bank industries, an Arab-controlled bank or irrigation projects to enhance the productivity of Arab farm land in the Jordan Valley -- there are many objections from Israelis who see such measures as barriers to absorbing the occupied territories.

"My fear is that this is not something aimed at welfare such as raising medical standards, but is going to turn into a political structure," said Yuval Neeman, the leader of the right-wing Tehiya Party in Israel's parliament.

The simmering debate was fueled by Prime Minister Shimon Peres' trip to the United States in October. Just before Peres' departure, Defense Minister Yitzhak Rabin announced several steps, including a loosening of censorship and an increase in the amount of money Palestinian residents are allowed to bring into the West Bank from Jordan.

Rabin also announced that he was holding discussions with Arab businessmen on their application to open the first Palestinian-controlled bank in the West Bank, to be located in Nablus. He has since announced the Defense Ministry's tentative approval.

While in the United States, Peres also met with a joint Arab-Jewish group of American businessmen and professionals that included Howard Squadron, a former president of the American Jewish Congress, and Najeeb Halaby, a former chairman of Pan American World Airways and the father of Queen Noor of Jordan, King Hussein's wife. The group formed around the "quality of life" issue, to improve economic conditions in the West Bank and Gaza Strip.

While some in Israel applauded these efforts, Vice Prime Minister Yitzhak Shamir of the Likud Bloc wing of the government publicly questioned why, during a time of economic crisis in Israel, "American Jews would want to improve the quality of life in an area where the standard of living has improved tremendously since 1967."

Later that month, Neeman flew to New York to address a new group formed by American Jews, in reaction to the Squadron-Halaby organization, to spur economic development in the Jewish settlements of the West Bank.

U.S. officials have kept a low profile throughout the debate, but it is largely U.S. money, and how it will be used, that are at stake. The funds come from the Agency for International Development and are funneled to the West Bank and Gaza through six private voluntary agencies that sponsor projects.

In most cases, the U.S. money is matched by funds raised by local Palestinians or provided from such outside sources as the Jordanian government.

Between fiscal year 1975, when the program was authorized by Congress, and this year, $51.6 million has been allocated. During the same period, the United States has provided Israel with $14.3 billion in grants and $10 billion in low-interest loans.

Last spring, in the only comprehensive study of how this program is working, Meron Benvenisti, a former deputy mayor of Jerusalem and a sharp critic of Israeli policy in the West Bank, said occupation authorities have been able to channel the U.S. AID funds toward their own objective of "pacifying" the territory under Israeli rule.

From a study of 358 proposed projects between 1977 and 1983, Benvenisti concluded that Israeli authorities had reversed the priorities of the private agencies by disapproving projects aimed at industrial and agricultural development while taking a more positive attitude toward social, charitable and public-works proposals.

Benvenisti also argued that the use of U.S. funds in the West Bank for "consumption-oriented" projects such as roads and water and electricity grids that are normally provided by the local government frees Israeli public funds for other purposes, including expansion of Jewish settlements in the territory.

U.S. officials will not comment publicly on the Benvenisti report. But they do not dispute his assertion that their role in seeing that projects are actually implemented has been deliberately passive, leaving the final decisions in Israeli hands. Privately, they question his assumption that public works projects such as roads and electricity lines are not a part of economic development and they defend the overall impact of the AID program.

"The successes have outnumbered the failures," one official said.

Many of the failures are known to Henry Selz, director of American Near East Refugee Aid (ANERA), one of the six private voluntary agencies that work in the West Bank and Gaza Strip with AID funds.

"The issues haven't changed over the years," he said in a recent interview. "The Benvenisti study is just the first time they are out on the table."

Economic development is seldom a subject of passionate public debate, but in the crucible of the Arab-Israeli conflict it can arouse emotions. At the time of the Wadi Faraa dispute, Selz noted, the independent newspaper Maariv, under the headline, "U.S. Helping Arabs Take Control of Water Sources in West Bank," suggested an American scheme to "put the faucet in Arab hands."

"These projects are so small and it's all so absurd," Selz said. But he acknowledged the underlying political issues in the debate, which Israelis, from their own experience, well understand. He quoted an unnamed Israeli labor union official who told him:

"The Jews used the cooperative movement as a major tool to create the state. So if you detect a certain nervousness about a revival of the cooperative movement on the West Bank, this is the reason."

Neeman, of the Tehiya Party, used the same analogy in discussing the proposed Arab bank in Nablus, a current focus of attention. The bank would not involve any U.S. development funds, but it could evolve into the kind of independent Palestinian institution that Neeman and others fear.

"The talk of an Arab bank gives me the impression that what people are searching for is not a raising of the standard of living, but the creation of national organs that would be a state in being," he said.

Eli Tsur, director of welfare activities for the West Bank and Gaza Strip in Israel's Labor and Social Welfare Ministry, is a key figure in the process of approving proposed projects in the territories. He maintains that Israeli authorities are ready to approve as many projects as possible for schools, hospitals, orphanages, roads, water and electricity grids.

Sometimes the issues are purely political. If anyone connected with a proposed project is found to have links with the Palestine Liberation Organization "we don't approve," Tsur said.

As the debate has heated up in Israel, the Arab landowners around Nablus have resubmitted a proposal for the Wadi Faraa Irrigation Project. Tsur suggested that it now stood a better chance of approval.