Jewish leaders reacted with anger after the German pontiff issued a decree welcoming Richard Williamson, 68, back into the Church.
Three other breakaway bishops excommunicated by John Paul II in 1988 were also included in the decree.
All had been ordained without Vatican permission by the renegade French archbishop Marcel Lefebvre, who flatly rejected the reforms of the Second Vatican Council.
The Vatican decree referred to the need to overcome the "scandal of divisiveness" and seek reconciliation and "full communion" with Lefebvre's order, the ultra-conservative Society or Fraternity of St Pius X.
It lifted the excommunication not only of Bishop Williamson, rector of the Seminary of Our Lady Co-Redemptrix in La Reja, Argentina, but also of Bernard Fellay, the leader of the order, Alfonso de Gallareta, and Tissier de Mallerais.
Renzo Gattegna, head of the Union of Jewish Communities in Italy, said that the rehabilitation of Bishop Williamson was "terrible not only for Jewish people but for the whole of humanity". He said Italian Jews would refuse to take part in joint prayers with Christians on Tuesday marking Holocaust Day, known in Italy as "The Day of Memory".
Some Vatican officials also said privately that although the Pope's aim was to unite the Church, his move would have the opposite effect, since the Lefebvrists - who have 500 priests and an estimated 600,000 followers worldwide - were "ultra conservatives who never accepted the reforms of the Second Vatican Council".
"The Church will pay a price for this," one Vatican prelate said. "The Pope is undermining the legacy of John Paul II". Others recalled that before his election three years ago Pope Benedict's hardline conservatism as head of the Congregation for the Doctrine of the Faith - the successor to the Inquisition - had earned him the nickname "the Panzerkardinal".
"This is not so much an act of grace as a surrender" said Marci Politi, the veteran Vatican watcher. Benedict wanted a new era of reconciliation, "but the new era has begun with a lie. The Pope has made a openly-declared and unshakeable anti-Semite a legitimate Bishop".
Archbishop Lefebvre, who died in 1991, had set up "a fanatical and reactionary counter-Church which openly contested, repudiated and defamed all the crucial points of Vatican II, from respect for the Jews to modernisation of the liturgy" Mr Politi said.
Gianni Gennari, a theologian and contributor to the Italian Catholic daily Avvenire, said it was "shameful that the lifting of the excommunications was not accompanied by any repentance whatever on the part of the Lefebvrists".
Bishop Williamson, who has said that the Vatican is controlled by Satan and that the Jews are bent on world domination, reiterated in a broadcast last week on Swedish television that the historical evidence was "hugely against six million having been deliberately gassed as a deliberate policy of Adolf Hitler. I believe there were no gas chambers".
He added: "I think that 200,000 to 300,000 Jews perished in Nazi concentration camps, but none of them by gas chambers."
Prosecutors in Regensburg in Germany, where the interview took place - and where the Pope once studied and taught - have opened an inquiry. Holocaust denial is an offence under German law.
Fr Federico Lombardi, the papal spokesman, insisted that the lifting of the excommunications had "absolutely nothing to do" with Bishop Williamson's views on the Holocaust. "One is not connected to the other," he said.
Vatican Radio reported that the bishop's statements had been condemned by other members of the St Pius X fraternity.
Bishop Fellay expressed "filial gratitude" to Pope Benedict, saying the fraternity wanted to help him to "remedy the unprecedented crisis shaking the Catholic world".
In his Angelus prayers today the Pope prayed for Christian unity on the 50th anniversary of the announcement of Vatican II by Pope John XXIII, but did not refer to the row over the rehabilitations.
Instead, marking the feast of the conversion of St Paul on the road to Damascus, he praised the Apostle for abandoning Judaism for Christianity.
The Pope said some preferred not to speak of conversion, since the apostle had been "a fervent Jew" who had simply passed "from one faith to another".
However, St Paul offered "a model for every authentic Christian conversion", the pontiff said.
Earlier this month Elia Enrico Richetti, the chief rabbi of Venice, said Jews had been deeply offended by the re-introduction by the Pope in March last year of a Good Friday Latin prayer for the conversion of the Jews as part of the revived Tridentine Mass. "We are moving toward the cancellation of 50 years of Church history," the rabbi said.
Other Catholic-Jewish tensions include plans by the Pope to beatify Pope Pius XII, the wartime pontiff accused by critics of failing to speak out in defence of Jews during the Holocaust.
The Vatican insists that Pius XII helped Jews while avoiding public statements that would have made matters worse, and has demanded the removal of a plaque attacking Pius XII at the Yad Vashem Holocaust memorial in Jerusalem.
The Pope's planned trip to Israel in May is in doubt after a row following a declaration by Cardinal Renato Martino, the President of the Pontifical Council of Justice and Peace, that Israel's offensive in Gaza had turned it into a "big concentration camp".
The Pope has twice visited synagogues, in the US and in Germany, and sought to make amends with the Islamic world after a speech at Regensburg two years ago in which he appeared to suggest that Islam was inherently violent and irrational.
However, he recently declared that inter-religious dialogue "in the strict sense of the word" between Christians, Jews and Muslims was "not possible".
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(Source: TTUK)