The US has suspended co-operation on several development projects and frozen delivery of night-vision equipment.

An official at the US embassy in Tel Aviv said he was aware of the reports but would not comment on them. He said the information about the sanctions had come from the Israeli government and not the US.

The sanctions have been in place for at least three months and were approved by Donald Rumsfeld, the defence secretary, and Condoleezza Rice, the secretary of state, seven months ago, according to the reports.

Although the US is primarily angered by the behaviour of civil servants whose tenure stretches back to the Labour government of Ehud Barak in 2000, the crisis threatens Israel's relations with the US.

A report in the Israeli newspaper Ha'aretz concluded: "Following the crisis, one can sense the repulsion toward Israel among lower- and middle-ranking officials in Washington.

"More and more of them are saying that it is not worth doing business with Israel."

The US believes that Israeli officials lied to them about the export of Harpy Killer drones to China.

The officials claimed that Israel was merely refurbishing old drones which had been exported with American consent. The US argued that the drones had been upgraded using new technology which it had shared with Israel.

The US fears that China is becoming increasingly well-armed and may seek to settle longstanding territorial and political disputes by the threat and use of force.

China has repeatedly threatened Taiwan with attack if it declares independence, and South Korea and Japan are concerned about China translating its size into military power.

The US is also keen that the EU maintain its arms embargo on China, which was put in place after the crushing of pro-democracy protesters in Tiananmen Square in 1989.

It is the second time that the US has had a serious quarrel with Israel over arms sales. In 2000, Israel was forced to suspend the sale of radar equipment to China at the insistence of the US. Israel was then obliged to pay millions of pounds in compensation for breach of contract.

Israel receives at least £1.5bn in grants annually from the US government as well as around £1bn from individuals and the sale of government bonds. Most of its military equipment is American-made or incorporates American technology.

US subsidies and joint ventures have given Israeli arms companies the opportunity to grow and sell arms and technology all over the world. Israel is believed to be the 10th biggest arms trader in the world.

The Israeli defence ministry said it was holding "quiet and specific talks with the United States with the goal of resolving the misunderstanding that has developed".

According to Ha'aretz, the US has indicated that normal relations will not be resumed until Israel agrees to a series of humiliating conditions.

Israel must provide information on 60 recent arms deals with China and agree to American supervision of arms dealings which might be seen as "sensitive" by the US, the report said.

The US wants to know how deals are supervised by Israel to understand how errors occurred in the past and how they can be prevented in future.

Finally, Israel and the US will jointly produce a memorandum of understanding on future coordination and supervision of Israel's arms exports.

Other reports suggested that the US was insisting that four Israeli officials at the ministry of defence be fired for their role in the alleged deception.