The Environmental Protection Agency decided yesterday to permit continued use of the nation's most widely applied herbicide -- alachlor -- despite its potential for causing cancer and contamination of drinking-water supplies in farm communities.

According to the agency, the "substantial" benefits of using the weed killer on corn, soybeans and peanuts -- farmers alone are estimated to save $400 million per year -- outweigh those risks.

Forgoing restrictions on crop use, the EPA did impose new rules on methods of application to protect operators.

Environmentalists criticized the EPA for failing to recognize the increasing threat of alachlor -- the agency considers it a probable human carcinogen -- to rural drinking-water systems that lack the capacity to treat the chemical.

"This chemical is showing up in drinking water all over the place, and it can't be removed," said Maureen Hinkle of the National Audubon Society. "It's an outrage that EPA is backing away from regulating it."

A spokesman for Monsanto Chemical Co., sole producer of alachlor, said the EPA decision is "consistent with the top scientific assessments" of the pesticide and "underscores our confidence that the product is safe when used properly."

Yesterday's decision ends a three-year EPA investigation prompted by tests results showing cancer in laboratory animals exposed to alachlor. The lengthy review pitted environmentalists against Monsanto, which produces at least 80 millions pounds per year of the pesticide under the trade name Lasso. It represents 10 percent of all herbicides used by U.S. farmers and annually reaps hundreds of million of dollars in sales for Monsanto, according to its spokesman.

Since the EPA review began in early 1985, Canada banned the chemical and the state of Massachusetts, after finding alachlor contamination in five private wells, ordered a halt to its use starting Jan. 1.

In its 118-page decision, the EPA estimated that alachlor residues on food cause one additional cancer for every million people exposed over a lifetime. The risk is "reasonable" considering the herbicide's benefits, the agency said.

Acknowleding a risk for farmers who apply the chemical, the agency restricted its use to certified applicators and required health warning labels and special devices to limit their exposure.

Investigators focused on environmentalist concerns about drinking-water contamination by alachlor, a durable chemical used on crops that favor porous soils. According to Hinkle, the herbicide has been detected at high levels in surface and groundwater of 10 states. It also has turned up in tap water, she said.

But the EPA said a study of 50 communities in the Midwest that rely on lakes and streams for their drinking water shows that alachlor was found only in small doses, posing a cancer risk in the range of one in a million, which it considered acceptable.

In communities that draw their water from underground sources, low concentrations of alachlor were found in a small percentage of wells, according to the agency. But officials concluded that the information was too limited to make a final determination. And they have ordered Monsanto to submit a nationwide monitoring study in 1989.

EPA weighed the risks of alachlor against the benefits to farmers in lower costs of weed control and better yields.