Israel's most senior Roman Catholic leader has said Bethlehem has become an "immense prison" since the erection of the West Bank barrier.
Michel Sabbah said winning hearts was the key to peace
Michel Sabbah, the Latin Patriarch of Jerusalem, called for all barriers between people to be dismantled.
He was joined by Palestinian leader Mahmoud Abbas, ambassadors from several countries and thousands of Christians for Christmas Eve mass in Bethlehem.
Israel says the barrier is defensive, but Palestinians see it as a land grab.
'Bridges of peace'
The patriarch, who is the pope's representative in the Holy Land, called for the barrier to be removed and said "bridges of peace and love" should be built instead.
He said Palestinians had a right to their own homeland and the Israelis should have security in return.
But he said those who held power had to realise that they could not rule through violence, but only by winning the hearts of both Palestinians and Israelis.
"Nobody needs checkpoints in the Holy Land," he said.
Mr Abbas, participating for the first time in Christmas celebrations since his election as Palestinian Authority president in January, said his people were "seeking a bridge to peace instead of Israeli walls".
Earlier, Israeli Prime Minister Ariel Sharon called Christian leaders with Christmas greetings and expressed his hope that the new year would bring peace and security for Israel and the Palestinians.
"We all need it and I intend to make every effort to reach it," he said in a statement.
Choirs and bunting
A ceasefire in place between Israel and most Palestinian militants has brought in many more visitors than last year.
Some 30,000 tourists were expected to visit Bethlehem over the Christmas weekend - about 10,000 more than last year.
Israeli officials said about 7,000 tourists had already gathered in the city by Saturday evening.
Israel has built a new crossing point in the eight-metre- (25ft-) high concrete barrier to enable thousands of foreign visitors to pass into Bethlehem.
Throughout the day choirs, marching bands and bagpipe players entertained the crowds, before they gathered in Manger Square to watch a procession led by the patriarch.
Christmas lights, bunting and lines of fluttering Palestinian flags created a sense of cheer despite the sombre political background.
The BBC's Dan Damon in Bethlehem says many Christian pilgrims braved heavy wind and rain to wait outside the Church of the Nativity to celebrate Midnight Mass.
But he says there is still tension, with Palestinians complaining about the lack of jobs and frequent arrest raids by Israeli troops.