NEWS ANALYSIS : U.S. Believes Compromise Will Come if Talks Get Going : Diplomacy: The toughest task is to keep irreconcilable Israeli-Arab differences under wraps long enough to get the rivals to sit down.

During one of Secretary of State James A. Baker III’s shuttle visits to Jerusalem in the spring, a Palestinian negotiator who met with him began a speech with the ritual reference to the Palestine Liberation Organization as his sole, legitimate leader.

Suddenly, Baker dropped his usual Texas cool and blurted: “I know you’re PLO! I know! Just don’t say it anymore!”

The outburst exposed the central dilemma standing in the way of potentially historic Middle East peace talks: How to keep irreconcilable differences between Israel and the Palestinians under wraps long enough to get peace talks under way?

Israel’s Prime Minister Yitzhak Shamir put the issue squarely in Washington’s lap by demanding assurances that Palestinians at the talks would represent neither the PLO nor be residents of Jerusalem, which Israel claims as solely its own.

The Palestinians made opposite demands: They insist that the PLO be at the table and warn that no talks can take place without the presence of a Jerusalemite from the Arab east side.

To openly settle the issues in favor of one party or the other, especially the emotional question of Jerusalem, runs the risk of sinking the entire effort, one that has become the showcase test of Bush’s quest for a “new world order” in the wake of the Persian Gulf War.

So the Americans are working to skirt the problems, Israeli officials and Palestinian informants say. First, they are trying to construct an elaborate fig leaf to hide differences so that talks can begin. As negotiations move forward, so the plan goes, agreements will start to flow out, and by the time intractable issues are on the table, the stakes will be too high for either side to withdraw. Compromise will be easier.

Call it warm-bath diplomacy: Get everyone into the tub and splashing around, and save the hard scrubbing for later.

If this sounds familiar, it should. Last year, Baker, the Israeli Foreign Ministry and the PLO (through Egypt) tried to put together a formula to jump-start Israeli-Palestinian talks. The talks were supposed to pave the way for elections in the Israeli-occupied West Bank and Gaza Strip, in which Palestinians would choose a negotiating team.

Because Shamir rejected a role for the PLO, Baker proposed the presence of a Palestinian in exile, presumably someone with nationalist credentials but not an official member of the organization, which Israel considers irredeemably terrorist. To overcome Shamir’s objections to Jerusalem representation, Baker offered participation of a Palestinian who resided in the city but kept an address in the West Bank.

Shamir turned down the proposals. His own Likud Party opposed them, and he himself complained that direct talks with Arab states, also a part of his peace plan, had been overlooked.

This year, a situation has emerged that may make Shamir more amenable to some form of camouflage, Israeli officials say. Direct talks with Arab states are in view. The key is Syria, which surprised almost everyone by agreeing to talk with Israel and accepting a format proposed by President Bush.

On Tuesday, with unaccustomed abandon, Shamir compared Syria’s move to the dramatic gesture of Egypt’s late President Anwar Sadat in seeking peace with Israel.

A Cabinet minister who is considered a protege of Shamir spoke with exceptional optimism in an address that Likud officials described as a reflection of Shamir’s thinking. “I have no doubt that Syria’s agreement to hold direct negotiations with Israel is a revolutionary move,” Police Minister Ronni Milo told Parliament on Monday. “We have never known anything like it.”

A senior Foreign Ministry official who is deeply involved in efforts to arrange talks commented: “The difference between now and last year is that Shamir can get what he wanted--talks with the Arabs.

“To turn this chance down would be to say, after 43 years, that Israel is not really looking for peace.”

Foreign Ministry officials, considered more dovish than the members of Shamir’s own circle, have tried to sell the prime minister a list of favorable byproducts that they believe will flow from talks:

* An end to tense relations with the Bush Administration and an easier road for new Israeli aid requests.

* Diplomatic ties with the Soviet Union, which would co-sponsor the talks.

* De facto recognition from Arab states as each sits down for face-to-face negotiations with Israel.

* Warmer relations with the European Community, which is sending an observer.

* Trade benefits in the united Europe of 1992.

Still, the Palestinian issue weighs heavily. Shamir has spent much of his political career campaigning to hold onto occupied land and populate it with Israelis.

“He simply won’t abide the embarrassment if a Palestinian stands up at the opening meeting, says he’s from the PLO and demands a state,” said the senior Foreign Ministry official. “Israel will pull out.”

Palestinian leaders in the West Bank and Gaza are divided between a group that favors rejecting talks unless there are assurances of getting statehood and another that says getting the talks started is the main issue and that results will come later.

The group willing to talk is led by Faisal Husseini, a pro-PLO leader and member of an old Jerusalem family who has met with Baker during each of the secretary’s six trips to Jerusalem. Ironically, Husseini, among the most moderate of all public leaders, may fall victim to the fig leaf scenario. His affiliation with the PLO, not to mention his Jerusalem address, are both well known to Israelis. A spot for him on the Palestinian team may be too obvious a nod to the Palestinians.

Husseini seemed to be expressing a personal agony the other day when he told reporters that “representation of East Jerusalem is something vital.”

Hanan Ashrawi, another Palestinian representative who met with Baker this week, pleaded that if the Palestinians could not openly send whom they wanted to send, then Washington should at least signal that the Palestinians would gain what they want from the talks--eventual statehood.

There are also compelling reasons for the Palestinians to go forward, some Palestinian political analysts say: Talks would represent the only concrete gain from a painful 3 1/2-year uprising against Israeli rule; they would break the isolation of Palestinians in the world arena for backing Iraq in the war over Kuwait, and they would provide a chance, for the first time, to negotiate an end to Israeli occupation.

The Palestinians are haunted by the knowledge that a year ago, they were in a position to take center stage along with the Israelis--no Jordanians, no Syrians, no other diversions.

This realization has led to a kind of rejectionist despair. Ruiyad Malki, a PLO affiliate and educator who led a factional boycott of the Baker talks, complained that what Washington “is offering us is much less than what we deserve as a people.”

Palestinians say the decision rests with the PLO. Mahdi Abdel-Hadi, a prominent political analyst in Jerusalem, declined to predict the answer but offered a cautionary cultural lesson:

“Muslims are taught to say no early in life. We say there is no other god but Allah. Saying no is sometimes the easiest thing for us--there is never any criticism when you say no.”