In August 1981, the Reagan administration was poised for a major legal confrontation between the Navy and the nation's largest defense contractor, General Dynamics Corp.

Top General Dynamics executives made the highly unusual claim that the government had insured the company against faulty workmanship and therefore owed the company $100 million to cover cost overruns on nuclear submarines.

Outraged Defense Department officials ordered General Dynamics removed from competition to build three new nuclear submarines and awarded the job to the only competing firm. The Navy threatened to sue General Dynamics for poor performance, and Navy Secretary John F. Lehman Jr. publicly blasted the company's claims as "preposterous."

Two months later came a startling reversal. To the expressed amazement of the defense industry, Lehman appeared side by side with General Dynamics Chairman David S. Lewis at a Pentagon news conference and announced that the dispute had been settled. The company would drop its claims, and the Navy would begin negotiating new submarine contracts.

The private high-level discussions that helped lead to the settlement are the subject of a newly revealed tape recording reflecting Lewis' account of a rancorous 2-hour 10-minute meeting with Lehman that August. On the tape, Lewis described Lehman's anger at him for having taken the matter to White House counselor Edwin Meese III. The tape, obtained by The Washington Post, offers a detailed look at the private power politicking between company officials and their most important customer, the federal government.

Press reports after the settlement suggested that General Dynamics had dropped its claims in return for a hefty increase in profits on new submarine contracts. Lehman vigorously denied them.

But the tape outlines how, in Lewis' view, just such a deal began to take shape after months of heated exchanges between the company and the Navy. The recording, turned over to the Justice Department by P. Takis Veliotis, a former executive vice president of General Dynamics, was of a 30-minute telephone report by Chairman Lewis of his meeting with Lehman at the Pentagon Aug. 25, 1981.

Lehman said yesterday through a spokesman that Lewis' account was "not . . . complete and accurate," and that "no one ever brought pressure on Secretary Lehman to settle with General Dynamics."

Lewis' taped account to Veliotis of events preceding the settlement includes:

* Lewis boasting that he had angered Lehman because Lewis had gone to the White House to complain about Lehman to presidential counselor Meese. Lewis said Lehman "was mad because we went to see Meese . . . and I said, 'You bet . . . we went around to Meese. We were not getting any satisfaction [from you].' "

* George A. Sawyer, Navy assistant secretary for shipbuilding, appearing eager to settle the dispute, ran out of the Pentagon building to a departing limousine to tell Lewis, "I want to give you terms [on new contracts] that get you out of this." Sawyer says he does not recall the comment.

* General Dynamics being advised by former Navy secretary Edward Hidalgo on how to deal with Lehman, his successor.

One overriding conclusion conveyed by Lewis on the tape was that the company would have to abandon its attempt to have the Navy pay cost overruns although, by playing tough, company officials might extract higher profits on new submarine contracts. The projected profits would effectively erase the $100 million in overruns, according to Navy and company officials.

Lewis also conveyed on the tape that he believed that his White House visit to Meese had the desired effect, saying: "It was obvious to us that somebody told him Lehman to settle."

Lehman and Meese denied last week through spokesmen that Meese had any role in the settlement. Meese told the Senate Judiciary Committee during recent hearings on his nomination as attorney general that he met with Lewis Aug. 7, 1981, determined his complaint was not a matter for White House involvement, and decided to call Defense Secretary Caspar W. Weinberger about the problem.

A spokesman for Meese said last week, "At no time did Mr. Meese take any position on behalf of General Dynamics or attempt to influence the Navy's decision."

Weinberger was traveling in Europe last week and was not available for comment.

Sawyer said in an interview that Meese called Weinberger and perhaps also Lehman after Lewis visited Meese. Sawyer said Meese suggested that Navy officials meet with General Dynamics officials to discuss the dispute but did not try to influence the outcome.

Lehman said through a spokesman that he does not recall discussing the matter with Meese but that a member of Meese's staff had conveyed to him a message instructing the Navy "to continue doing what it was doing . . . . "

Sawyer is under investigation by the Justice Department for the manner in which he left his Navy post two years later for a position at General Dynamics.

A source close to Sawyer said last week that a federal grand jury in New Haven, Conn., is investigating whether Sawyer violated conflict-of-interest laws by discussing job opportunities with General Dynamics officials for nearly three months before leaving the Navy Department in June 1983.

The source said Sawyer has told federal investigators that, in early March 1983, Lewis telephoned to ask him to consider joining General Dynamics. Sawyer traveled at company expense for "exploratory" job talks in March and in mid-May, but did not disqualify himself from supervising Navy contracts with the company until late May, the source said.

The source close to Sawyer said Sawyer should have disqualified himself from dealing with General Dynamics after he initially expressed interest in discussing a job there. The source said Sawyer is confident that his actions did not amount to a criminal violation of conflict-of-interest laws, which prohibit officials in government service from negotiating for or arranging employment with a contractor unless they disqualify themselves from contracting decisions.

Sawyer signed official documents May 5, 1983, ordering the Navy to negotiate with General Dynamics and another firm for submarine-construction contracts. The source said Sawyer did not participate in the substantive negotiations.

The tape of Lewis' remarks was made by Veliotis without Lewis' knowledge when Lewis telephoned him from Washington to report on the meeting with Lehman. Veliotis then was general manager of Electric Boat, General Dynamics' submarine-building division at Groton, Conn.

Veliotis resigned from General Dynamics in May 1982 and, in September 1983, was indicted by a federal grand jury in New York for allegedly sharing kickbacks on unrelated ship construction. Currently living in Athens, he has not returned to face indictment and is listed as a fugitive by the Justice Department.

Electric Boat had based its claims against the Navy on an insurance clause used for 40 years in Navy contracts protecting contractors from "all risks" during construction. The Navy insisted that it would not insure a contractor against employes' poor workmanship, and officials said no contractor had ever filed such a claim.

Veliotis said in a recent interview that Lewis told the company's board of directors in December 1981 that the settlement approved by Lehman would net the company more than $100 million in new contract benefits, eliminating the financial penalty of the overrun.

In a statement, the company said, "The meetings with Secretaries Lehman and Sawyer and Meese were perfectly proper. We neither sought special favors, nor were any offered or provided.

"We were advised by our counsel and others," the statement continued, "that our insurance claims were valid. The Navy adamantly refused to pay the claims, and we dropped them to avoid lengthy litigation and to preserve our opportunities to compete for future contracts."

Meese, who is awaiting Senate confirmation as attorney general, could face several politically sensitive questions on investigations focusing on General Dynamics.

Departing Attorney General William French Smith last summer recused himself from decision-making in these investigations, saying his former law firm had performed legal work for the company.

According to sources familiar with the series of Justice Department investigations, federal prosecutors have discussed calling Meese as a "fact witness" in their investigation. That would almost certainly remove Meese from any decision-making role in the investigations.

Meese declined to say last week whether he would disqualify himself from the General Dynamics investigation.

A half-dozen congressional committees and the Justice Department are probing allegations that General Dynamics engaged in a pattern of fraud in dealings with the Navy over the last 10 years. The company has vigorously denied the allegations.

Many of the allegations against General Dynamics have been made by Veliotis, who is cooperating with federal prosecutors and has provided several tape recordings and documents. Justice Department attorneys are to meet for the fourth time with him this week in Athens.

Justice Department officials have told Veliotis that they intend to use him as a witness before the federal grand jury that began taking testimony in December in New Haven.

The 1981 dispute between General Dynamics and the Navy began after the submarine yard discovered serious quality-control deficiencies on several Los Angeles-class nuclear submarines under construction.

Inspectors found falsified welding records, and serious concern developed that the submarines might not be safe. The company was forced to begin a massive reinspection that required ripping out portions of nearly completed subs and reconstructing them under tighter supervision.

By early 1981, Electric Boat had notified the Navy that it intended to file claims against the Navy for the poor workmanship and costly reinspection. Internal estimates showed that the company faced new cost overruns of between $100 million and $200 million.

In June 1981, General Dynamics filed a claim on the first defective submarine. According to the tape, Lehman warned Lewis that he would never be awarded another Navy ship contract if he pursued the claim.

Late in the morning of Aug. 25, according to the tape, Lewis and his chief Washington lobbyist, Edward J. LeFevre, preparing to meet Lehman, met with Hidalgo, now a General Dynamics consultant. Hidalgo advised Lewis to "let Lehman know in no uncertain terms what we thought about his" criticism at the National Press Club of the company the previous week and added, according to the tape, "Don't make any deals with this man." Hidalgo, in an earlier interview, said he did not recall the conversation.

Early that afternoon, Lewis and LeFevre visited Lehman in his office, and Lewis said on the tape that he was cool to Lehman, blasting him for going "to the . . . press and saying those terrible things about us."

According to the tape, Lewis then said Lehman should find a way to compensate General Dynamics if the Navy expected the company to drop its insurance claim. Lewis said on the tape that he knew Lehman's files included a legal opinion commissioned by Hidalgo and showing that, while General Dynamics' insurance claim was not "ironclad" from a legal standpoint, it had merit.

Lehman replied, according to Lewis, that the Navy "cannot afford to let this thing be tested . . . . We cannot afford to let this thing go forward."

Lewis told Veliotis on the tape that he had also told Lehman, "I don't know who you think you are kidding" by making public statements that the Navy would not finance insurance protection for poor workmanship.

Referring to negotiations between the Navy and General Dynamics' only competitor, Newport News Shipbuilding and Dry Dock Co., for new submarine contracts, Lewis said, "You've given those guys 18 percent earnings . . . . I said, 'Hell, you know, that's terrible, and if you want to do that with us, that's fine, too,' " according to the tape.

On the tape, Veliotis agrees with the position Lewis said he had taken with Lehman, saying:

"Yes, Dave, if they found a way with Newport News, . . . they increased their profit to 18 percent, . . . but he doesn't give us anything at all. He wants us to give up the bad workmanship insurance provision we have right now for nothing. Why doesn't he increase our profits?"

Lewis replied on the tape that he told Lehman, "Why the hell don't you come in and make a proposal to us? We just can't sit here forever and let . . . another bunch of stupid mistakes be made with people doing the wrong thing and proving that they are strong and dynamic leaders."

According to Lewis' account, Lehman answered: "Well, those opportunities are there," and then said: "We don't need a settlement where anybody loses."

Lewis said he agreed, adding that the company's insurance claim "is valuable as a pain . . . to you and you ought to be willing to give up something to get rid of it," according to the tape.

Lewis reported to Veliotis on the tape that Lehman had concluded, "Let's keep working."

At the end of the meeting, Lewis reported that Lehman "got mad with us because we went to see Meese" and "got mad because we went to see the Congress."

Lewis added on the tape: "He got on Meese, and I said, 'You bet . . . we went around to Meese. We were not getting any satisfaction. We had to go up there. We had to go,' so we didn't back down one iota and neither did they, but it's obvious to me that somebody told him to settle."

"That is good," Veliotis responded. "If they give us what they will give us, the four submarines , who are we to say no, Dave?"

Lewis told Veliotis that he was confident that a lucrative settlement would soon be reached because of statements made by Sawyer after the meeting. Lewis gave this account on the tape:

"By the time we got down to the Pentagon parking lot, . . . Sawyer runs out, asks for a ride over to Crystal City . . . and he said, 'Look, we've got to find a solution.' He said, 'This is just between us, we've got to figure out a way to sit down here and negotiate some contracts, give you some stuff that maybe we can do to find a solution.' "

Lewis replied, "Fine, that's what we're asking you to do. We're not giving this stuff up . . . without something in return."

Sawyer replied, according to Lewis, "Okay, I'm going to go to work. I can write you a contract [for several submarines] . . . and terms like those we've got with Newport News."

When Lewis raised doubts about whether the Navy would approve of higher profits for General Dynamics, Sawyer responded, according to Lewis' account, "You've got to trust me . . . . I want to have terms that get you out of this problem."

Lewis added, apparently for emphasis, "That's a quote."

Lehman said yesterday through a spokesman that Lewis' account on the tape recording is "not a complete and accurate account of the meeting. The secretary of the Navy's position is . . . that the argument that General Dynamics should be compensated for its own negligence is absurd and unacceptable."

On the question of higher profits for General Dynamics, "no contract . . . signed while John Lehman has been secretary of the Navy included an 18 percent negotiated profit margin."

Finally he said, "No one ever brought pressure on Secretary Lehman to settle with General Dynamics."