Annan's report on Friday followed a setback for hopes for an independence referendum in the phosphate-rich region.
The majority of nations represented on a key UN General Assembly committee signalled their disapproval of such a referendum by abstaining from a vote on the issue on Monday.
Annan said agreement on the proposed peace plan for self-determination for Western Sahara's people "appears more distant today" than when he last reported to the Security Council on the matter in April.
He reported a recent "escalation in public rhetoric" by the parties to the conflict and urged the council not to reduce the strength of the UN peacekeeping mission.
However, he noted a positive development in the renewal of family visits and called on donor countries to provide additional funds for confidence-building measures
Western Sahara's Spanish colonisers left the territory in 1975, and Morocco and Mauritania split it. War broke out the following year, and Morocco took over the whole of Western Sahara after Mauritania pulled out in 1979.
Annan: Proposed self-rule
appears even more distant
The fighting, which pitted 15,000 Polisario guerrillas against Morocco's US-equipped army, ended in 1991 with a UN-negotiated ceasefire that called for a referendum on the region's future.
But UN efforts to arrange a vote have been frustrated by disputes over who should be allowed to vote.
On Monday, the decolonisation committee voted 52 to zero with 89 abstentions to endorse a plan by former US secretary of state James Baker III for autonomy and a referendum to decide whether the desert territory on Africa's Atlantic coast should become independent or part of Morocco.
Morocco said the number of abstentions showed the plan should be revised.
It objected to the fact that the resolution did not mention the new special UN envoy to Western Sahara, Alvaro de Soto, who has been negotiating with the parties. De Soto succeeded Baker as mediator when the former US diplomat resigned in June.
Muhammad Salim Uld-Salik, the foreign minister for the Polisario rebel government, said the committee's approval of the resolution despite the abstentions "was a categoric rejection of the colonialist policy of Morocco in the Sahara."