While the crowds were larger than in recent years, the numbers were far smaller than during the boom period of the 1990s, when tens of thousands of people would flood into the West Bank town for Christmas. Many of Friday's visitors were local Palestinians, and in a cold, bitter rain, shopkeepers lamented that business remained in the doldrums.
Still, there was plenty to be merry about. After four years of fighting, there has been a marked warming of relations between Israel and the new Palestinian leadership since Yasser Arafat died last month.
In a sign of the growing cooperation, interim Palestinian leader Mahmoud Abbas was allowed to join the celebration, where he was greeted by cheering crowds. Israel prevented Arafat from attending the celebration since 2001, accusing him of advocating violence.
"It's a troubled time in the Middle East, but we live in hope," said Joyce Maykut, 55, a Canadian lawyer who came from her home in the United Arab Emirates. She said the hopeful atmosphere in the region attracted her to Bethlehem, despite safety concerns.
The celebrations in Bethlehem came as Christians around the world marked the holiday. At the Vatican, Pope John Paul II lit a candle for peace in his window before celebrating midnight Mass.
All through the day, pilgrims descended on St. Peter's Square, admiring the 100-year-old Christmas tree and a new fleet of Italian police minicars deployed in the latest security measure for the already heavily protected piazza.
The pope, who was a staunch opponent of the U.S.-led war in Iraq, said in a recent peace message that "violence is an unacceptable evil that never solves problems."
In Iraq, Defense Secretary Donald H. Rumsfeld paid a surprise Christmas Eve visit to some of the most dangerous areas of the country and told U.S. troops he believes they will defeat the insurgents.
"When it looks bleak, when one worries about how it's going to come out, when one reads and hears the naysayers and the doubters who say it can't be done, and that we're in a quagmire here," one should recall that there have been such doubters "throughout every conflict in the history of the world," he said.
The celebratory atmosphere in Bethlehem was a welcome contrast to recent years. During the fighting, Bethlehem has been ringed by Israeli checkpoints and a huge separation barrier has been erected.
However, on Christmas Eve, troops handed out candy as they allowed pilgrims, including Palestinians from throughout the West Bank, to pass easily through the roadblocks.
Abbas arrived in a large convoy Friday evening, the first time a Palestinian leader had been permitted to join the celebrations in four years. During the years Arafat was barred, a seat in the front row of St. Catherine's Church on Manger Square was left symbolically empty and draped in an Arabic headdress during the midnight Mass in respect for Arafat.
The celebration gave an important boost to Abbas, who is seen as the front-runner in the Palestinian presidential election Jan. 9. He received a loud ovation when he arrived and was mobbed by Palestinians whenever he appeared in public. Abbas, a Muslim, also stopped at a mosque to pray.
"We ask God and wish that all the religions in this country will live in peace and security," Abbas said. "I hope next year will be much better than the previous ones."
Israeli Prime Minister Ariel Sharon sent Christmas greetings.
Lt. Col. Aviv Feigel, head of the Israeli military liaison in the area, praised the close cooperation with his Palestinian counterparts for this year's celebration. "We certainly hope that these events are a positive sign for the future," he told Israel Radio.
Latin Patriarch Michel Sabbah, a vocal critic of Israel, kicked off the celebrations by leading a midday procession of about 1,000 Christians through Bethlehem. A Palestinian scout group band accompanied them, playing bagpipes and clashing cymbals.
By early evening, much of the crowd had cleared from Manger Square — the stone-paved courtyard outside the Church of the Nativity, which Christians believe is built on the grotto where Jesus was born. Several hundred people, mostly Palestinian teenagers, wandered the streets in a bitter rain.
The Israeli army said about 5,000 people had come to Bethlehem, including nearly 300 Palestinians permitted to travel across Israel from the Gaza Strip.
"I'm just delighted to be here," said Chris Shepherd, 41, of Columbus, Ohio. "It's absolutely incredible. I've just been overwhelmed by the friendliness of people."
One person who was barred from Bethlehem was Israeli nuclear whistleblower Mordechai Vanunu, who was detained at a checkpoint as he tried to travel to the city to attend Midnight Mass. Vanunu, a Jewish convert to Christianity, was released from an Israeli prison in April after completing an 18-year sentence for revealing secrets of Israel's nuclear program to the Sunday Times newspaper in London.
Under the terms of his release, the former technician at the Israeli nuclear facility in the Negev desert town of Dimona was barred from leaving Israeli territory and contacting foreigners.
The four years of violence has dealt a severe blow to Bethlehem's economy, which heavily relies on tourism. Dozens of souvenir shops and restaurants have shut down. Hotel rooms have remained mostly barren, and Christians have been moving abroad.
Palestinian shopowners said business remained weak.
"It's better than any (recent) year, but it's also bad," said Rony Tabash, a 23-year-old shopkeeper. He said he had rung up a mere $40 in sales, compared to thousands of dollars during the boom years.
Even so, Tabash, who spent the evening in his empty shop with relatives and friends, said he is hopeful things will get better. "Without hope, you cannot live," he said.
Israel's West Bank security barrier — which has effectively cut Bethlehem in half and dealt a further blow to the town's economy — has put a damper on this year's celebrations, Mayor Hanna Nasser said.
"This is the city of peace where we should have peace ... because the prince of peace was born here in the city, but unfortunately peace is missing still in this city," he said.
By HAITHAM HAMAD