I have read with hundreds of first graders and they virtually all must sound out some words.  This early in the school year, beginning readers read slowly and carefully and look for lots of visual clues from the pictures in their books.  They often must reread a book several times to understand what they are reading because they are so focused on decoding the words.

Reading Rockets has excellent guidelines for parents on what to expect when their young children begin reading:

http://www.readingrockets.org/article/30999

Many school districts conduct diagnostic tests with kindergarteners and first graders to identify potential learning problems with reading.  At the parent/teacher meeting, be sure to ask if any diagnostic testing has been done.  

In preparation for your meeting with the teacher, you can also take a look at Reading Rockets "Target the Problem" to see what potential difficulties exist.  The section on word decoding and phonics may speak to the teacher's concern:

http://www.readingrockets.org/content/helping/target2/target.html

Ask the teacher what her specific concern is.  "Sounding out words" is very typical beginning reader behavior.  Hopefully the teacher can be more specific (e.g., consistently mispronouncing letter patterns, beginning word sounds, ending word sounds, just guessing at words, etc.)

Also ask the teacher what action she has taken or that she proposes to address your daughter's "problem," such as a referral request to a reading specialist.

If you do not reach agreement with her on a plan, after the meeting arrange to talk to the lead teacher, principal or assistant principal about your concerns.

Thank you for your response! I checked out that website Reading Rockets and it described my daughter perfectly. I feel much more relaxed now that I read all this is normal progress in the begining of first grade. I know she will master this with practice, practice, practice. Thanks so much for pointing me in the right direction.

You WANT your child to sound out the words.  That is called decoding.  By first recognizing that each word is broken down into sounds and then slowly blending those sounds together is exactly what your child should be doing.  Now if your child takes the word "was" and reads "with" or a different word then this is time to be worried.  This means that they are not decoding.  Your child is on the right track to becoming a successful reader!

I have to confess finding your letter frightening. The teacher is so draconian, so rigid...but, in my opinion, wrong. Sounding out words has to be what we all do at the start. Phonics means SOUNDS.

I just want to share with you an article that can provide some background on the reading wars. Many so-called experts have been very wrong. See link.