Teachers, and their interpretations of reading level, vary. It isn't a science and it doesn't mean your child has moved backwards - it's likely just that both teachers interpret ate his level slightly differently.
I'm a Year 2 teacher and English lead. It's advised that children can "read" (without overt blending, which is what your son is doing) 80-90% of a book with about 10-20% being Unknown/challenging words, for them to be on the right level.
If he is sounding out every word, it is too challenging for him. It doesn't matter if he is sounding out loudly, or in his head, he is still having too blend those words to read them. The idea is that more and more words become sight words that are read instantly.
It's not that simple though, because it depends on the reading scheme!! Some books are purely phonic - in which case, he likely WOULD need to blend a larger percentage of the words in the book as they tend to focus on a specific sound that he will have been learning in school.
Other books are key word focussed and rely more heavily on sight word reading (these tend to be older reading schemes). Personally, I don't think these are great for very early readers as MOST small children learn better through a mixture of phonics and sight words.
My advice would be not to stress at all, there are lots and lots of variables on the process.
If you are worried, Google 100 high frequency words and encourage him to read these on sight, without blending. Learn a few at a time, stick them around your house etc.
Then ask his teacher which phonics phase he is currently working on, and use those sounds to blend words. (So if he's learning 'ai' you can do lots of word blending such as train, pain, chain, etc.)
This combination of sight key words, and blending trickier words, will really help him.
And definitely continue the love of reading!!
I hope that helps.