WITH Israel seemingly on the verge of accepting United States peace proposals, a potentially serious obstacle remained uresolved.Israel appears ready to concede on two procedural issues standing in the way of its attending a US-sponsored peace conference - granting a limited United Nations role and permitting the conference to reconvene. But the central issue of Palestinian representation in peace talks remains contentious. It was this same sensitive issue which foiled previous attempts by US Secretary of State James Baker III to bring together the parties in the Middle East, and which last year brought down the Israeli government. On Wednesday, as the world waited for Israel's response to the American call to join willing Arabs in the peace process, state-run Israel Radio said the US had granted Israel virtual veto power over the composition of the Palestinian delegates. "The United States has agreed that Israel will not be required to sit down with people who are not acceptable to Israel," explained an Israeli official earlier. Israel seeks to exclude from the peace process Palestine Liberation Organization (PLO) members or supporters, "exiled" Palestinians living outside the occupied territories, and people residing in Arab East Jerusalem, which Israel captured during the 1967 Six Day War and later annexed. The annexation has not been recognized by most other countries. Jerusalem is the thorniest issue. Israel fears that including Jerusalem residents would undermine its territorial claim to the eastern sector of the city, which Arabs hope to see as the capital of a future Palestinian state. But Palestinians claim to have US agreement that it is up to themselves, and not the Israelis, to decide who represents them. "The general principle that the Palestinians base themselves on, and on which the Americans agree, is that Palestinian representation is an independent Palestinian decision," says Hanan Ashrawi, a resident of East Jerusalem and one of three Palestinians who met here with Mr. Baker Sunday. "It is not subject to anybody else's interference, or anybody else's decision, or anybody else's veto," she said. A US official in Tel Aviv denied the US was trying to be all things to all people in its effort to convene a peace conference. "I reject that idea, that the United States is double dealing," he said. The official referred to Baker's visit last weekend, when the secretary told reporters: "There will be no assurances to any of the parties to this process that are not shared with the other parties." Shimon Shiffer, diplomatic correspondent for Israel's biggest newspaper, Yedioth Aharonoth, said he believes the Americans have in fact made assurances to both sides. But it will be Israeli demands that prevail, he added. "The Palestinians who will participate with the Jordanians [in a joint delegation] will have the green light from Israel," he said. "When it comes time for a conference, you will find no Palestinians from East Jerusalem and none from the diaspora." He said that perhaps at a later stage in negotiations, when the final status of the Israeli-occupied territories is to be determined, these groups will be represented. He attributed the weakened Palestinian position to the PLO's support for Iraq in the Gulf War. "This is their tragedy," Shiffer said. "After the last war they have no allies, and they will have to go along." Still, Palestinians show no signs of bending on East Jerusalem. Another Jerusalem resident, Faisal Husseini, who has led several delegations in meetings with Baker, called the issue a "red line." "The participation of Jerusalemites is not a condition. It is a fact which must be accepted," he warned. Ms. Ashrawi called on the Americans to stop making a priority of Israeli demands. "What is needed," she said, "is an independent American position that frees itself of Israeli constraints."