In presenting his modus vivendi proposal, Lansing implied that the American government accepted the German view that armed merchant vessels were warships: however, when the proposal was dropped by the Wilson administration, it seemed to be reverting to the British view on this question.
(A) when the proposal was dropped by the Wilson administration, it (incorrect: meaning error)
Pronoun it refers to the proposal thus the meaning is proposal seemed to be reverting. The proposal itself cannot revert. It is Wilson who seems to revert
(B) after it was dropped, the Wilson administration (incorrect: pronoun error)
It does not have any antecedent
(C) by dropping the proposal, the Wilson administration (best option)
Dropping is modifying administration and administers is reverting
(D) the Wilson administration dropped the proposal when it (incorrect: meaning error)
The same as option A has error
(E) when they dropped the proposal, the Wilson administration (incorrect: pronoun error)
Pronoun they does not have any antecedent.