Agriculture Secretary John R. Block is in a major internal battle with Office of Management and Budget Director David A. Stockman over the administration's forthcoming farm-policy proposals, including plans to cut back expensive and controversial milk-price supports.

Stockman circulated documents this month indicating that the administration had decided on elimination of the dairy program, which cost $6.1 billion over the last three fiscal years and has become a symbol of administration efforts to cut agricultural price support systems.

Block, however, is holding out for a scaled-down continuation of the dairy program, in which the government purchases surplus milk; he would simply reduce the support levels.

This impasse, according to sources, is only one of a number of policy disputes between Block and Stockman over ways to curb budget outlays and put the administration's "free-market" stamp on a 1985 farm bill.

They agree that costs should be cut, but how -- and who should control farm policy -- remain in dispute.

In addition to the dairy program, their differences include:

* A payment cap. Current law limits direct payments to participants in commodity programs to $50,000 a year. Stockman wants to take this down to $10,000 per farmer. Block and USDA are proposing no limitation.

* Target prices. Both Block and Stockman want to reduce so-called target prices, which determine how much grain, rice and cotton the government pays farmers directly when prices are low. Block apparently wants to reduce targets more quickly and, theoretically, cut federal expenses faster as well.

* Farm credit. Stockman has urged a shift from direct farm loans to federal loan guarantees, but USDA officials are studying other ways of extending credit to farmers in dire straits.

* Conservation. Block tends to support the idea of a "conservation reserve" that would pay farmers for removing some cropland from production as a way of stemming soil erosion, but Stockman is said to oppose the idea.

Those policy areas in which Stockman and Block are said to be in general agreement include a reduction of the so-called loan levels in the support programs, continuation of farm export credit programs, elimination of acreage-reduction and management supply programs.

The loan levels are especially important. They are the amounts farmers can obtain if they give their crops over to the government for storage.

The loan levels thus put floors under farm and food prices. The farmers can later redeem their crops if prices rise, or leave the commodities with the government if prices stay low.

Block and other administration officials have said repeatedly that their intention is to create a long-term farm policy that would cut federal spending by lowering price support levels to deter farmers from planting crops for which they may have no market.

This "free market" approach has met strong opposition from farm-state legislators in Congress, but Block and others contend that U.S. agriculture will capture more world markets if competitor nations realize that Washington will not prop up U.S. farmers' prices.

From a high of about $20 billion two years ago, federal farm spending is expected to be around $11 billion this fiscal year. By altering the programs -- that is, cutting crop support levels and direct subsidies -- the administration is seeking to cut spending by approximately $13.6 billion by the end of fiscal 1988.

The administration's formal proposals for reaching this goal will be included in its fiscal 1986 budget and in a proposed 1985 farm bill. Sources said that the final proposals are not expected to be ready until about Feb. 1.

Sporadic leaks from both OMB and USDA about possible administration proposals have touched off adverse reactions among some legislators and farm organizations and set the stage for bitter debate when Congress takes up the legislation next year.

"We've all done a disservice to ourselves, and it's going to make the job more difficult on Capitol Hill," said one USDA official. "It started with OMB trying to make an end run, an attempt to grab control of the farm bill process by letting out the story that we would kill the dairy program."

"Relations between us and the OMB are strained," the official continued. "You tend to get frustrated. There never was a disagreement on outlays. The problem is what policy tools do we adopt to achieve those cuts."