The Portland Trail Blazers have called off their trade of guard Jim Paxson to the Cleveland Cavaliers for forward Keith Lee, citing concerns raised by Portland's team physician about Lee's knees.

Angry Cavaliers officials vowed to contest the Trail Blazers' action.

Rod Thorn, the NBA's vice president in charge of operations, said a reversal of the draft-day trade must have league approval. "We'll have to see," Thorn said. "These are kind of uncharted waters."

"We had Keith Lee in for his physical last week and he failed it," said Bucky Buckwalter, Portland's vice president for basketball operations. "Dr. Bob Cook recommended that we not consummate the trade and the Trail Blazers are abiding by his recommendation."

Wayne Embry, Cavaliers vice president and general manager, said, "We're unhappy about it and we'll contest it."

The trade for Lee, a 6-foot-9 forward, was contingent on both players passing physicals with their new teams.

The teams negotiated by phone over the weekend in an effort to save the trade, but could come up with no mutually agreeable alternatives, such as compensation in the event Lee was unable to play because of the knees . . .

Boston Celtics center Bill Walton, who has played 10 NBA seasons, is expected to miss his fourth after undergoing surgery in Whittier, Calif., to make his right foot less vulnerable to injury.

Celtics General Manager Jan Volk said he is hopeful Walton can return in 1988-89, when the player will be 36. "There's no certainty in any of this," Volk said. "There's no certainty he'll be back. All we know is he had the same surgery on his left foot and he missed two seasons."

A broken navicular bone in his right foot limited Walton to 10 regular season games and 12 of Boston's 23 playoff games last season.