Gatsby has made it his life's work to establish himself financially and win Daisy back from Tom. In his mind, he ideally thinks that he and Daisy are meant for each other. When he finally confronts Daisy and Tom, he actually wants Daisy to tell Tom that she never loved him. Gatsby wants Daisy to sever all ties with Tom and essentially banish the four years she had been with him. So, when Gatsby sees their daughter, Pammy, for the first time, he is brought out of his idealism because Pammy is living proof of Tom and Daisy's relationship. Gatsby had probably denied Pammy's existence because she represents a part of Daisy's life with Tom that could not be erased. Seeing Pammy, Gatsby is probably disheartened because the reality of Tom and Daisy's marriage sinks in more profoundly.
Gatsby and I in turn leaned down and took the small, reluctant hand. Afterward he kept looking at the child with surprise. I don’t think he had ever really believed in its existence before.
To add: You might remember that when Nick tells Gatsby that he can't recreate the past (a common truism), Gatsby answers, "Why, of course you can." The only thing that would truly satisfy Gatsby is getting Daisy back AND erasing her history with Tom. That's why on that afternoon in the Plaza, he insists that Daisy tell Tom she never loved him. She can't do it. Although she seems poised to leave Tom and everything he represents, in the end she can't deny the fact that she, at some point in the past, loved him.
The child is physical proof of this love between Daisy and Tom. When Gatsby meets her (right before the argument in the Plaza hotel), he almost doesn't believe his eyes. Nick, the narrator, says that Gatsby didn't believe the child was real until that very moment.
Gatsby reacts with surprise when he meets Pammy, Daisy and Tom's young daughter, for the first time. Although he knew she existed, the reality of actually seeing her startles Gatsby. Nick tells us he "kept looking at her in surprise."
This provides more evidence that Gatsby has constructed a fantasy world for himself and Daisy that has shut out the reality of how situations change as time passes. He wishes to turn the clock back to five years ago and believes he can do so. He wants, through a sheer act of will, to step into a prior existence and start over. As the hot afternoon unfolds, however, he will be presented with obstacles to his goal. Pammy is simply the first.
Daisy seems to have gone out of her way to make sure Pammy is presented to Gatsby and to demonstrate that she loves the child. Daisy explains to her daughter, "your mother wanted to show you off." Daisy also says "come to your own mother that loves you," calls Pammy "blessed precious" twice and calls her "you dream, you. You absolute little dream."
Calling Pammy "blessed precious" twice, while cloying, communicates Daisy's love of the child. Calling her a "dream" twice is especially telling, showing that there is more than one dream to consider: Gatsby might have his dream, but Daisy also has hers, and that includes her child.
Nonplussed as Gatsby might be by the reality of Pammy, she is not a fatal blow to his plans. That will come later, at Plaza Hotel.