Worshippers, many of them Palestinian locals, packed the Roman Catholic church built near the grotto where the traditional site of Jesus' birth is enshrined.
"It feels like a giant family gathering," said Jonathan Croy, a 24-year-old musician from Birmingham, Alabama, who was visiting Bethlehem for the first time.
The Vatican's envoy to the Holy Land told The Associated Press he was hopeful that peace is possible.
"The message of Jesus (is) peace in the heart, joy and love for each other," papal nuncio Antonio Franco said as he entered the Church of the Nativity complex. "It's possible."
Clashes between Israeli security forces and Palestinian militants in the area have fallen off sharply from previous years, though towering concrete slabs that form a section of Israel's West Bank separation barrier were a reminder of hostilities that persist.
Israel built the barrier after a spate of Palestinian suicide bombings, but Palestinians say it's a land grab because it juts into the West Bank at various points, putting that land on the Israeli side of the enclosure.
Merchants had hoped the calm, coupled with sunny skies, would draw the tourists back. But most shops were empty, with most tourists entering the city briefly. "This year is miserable for us," said Ahmed Suleiman, 50, of Bethlehem, who has been selling olivewood rosaries, nativity scenes and other souvenirs in Manger Square for 30 years. "I call this season a dead season."
In the Gaza Strip, controlled by Hamas militants, about 80 people attended services at Gaza City's Roman Catholic Church, said Muhib Hadad, the church's Muslim guard. He said about half of Gaza's Catholic community of 300 had received hard-won Israeli military permits to travel to Bethlehem, keeping the congregation at home "moderately sized."
The once-traditional Christmas tree, raised in the city's central square of the unknown soldier, has not been seen since the Islamic militant Hamas was voted into power in 2006. Christians, most of them Greek Orthodox, number about 3,000 people in Gaza, a territory of 1.5 million Muslims.
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