About 1,000 people gathered in the famous piazza applauded as the pope lit a candle, symbol of peace.
Benedict's predecessor John Paul II began the tradition of setting up the creche in St Peter's Square in 1982 in a tribute to the rich Italian tradition of creche-building and the zeal and artistry involved.
Flanked by a giant Christmas tree, the illuminated structure 25 metres (yards) wide depicts the nativity of Jesus Christ, believed by Christians to be the son of God, whose birth is commemorated on Christmas Day.
Some of the figurines in this year's creche date from the mid-19th century.
The sundown event came a few hours before the pontiff was to celebrate Christmas Eve mass in the basilica.
As children put on a pageant and the Vatican orchestra performed, a long line of pilgrims waited to enter the basilica for the mass.
In a Vatican first, the traditional "midnight mass" was to begin two hours early this year in view of Pope Benedict's advanced aged of 82.
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