Israeli Prime Minister Benjamin Netanyahu issued a special Christmas greeting too, wishing Christians "a year of security, prosperity and peace."
Christmas is the high point of the year in Bethlehem, which, like the rest of the West Bank, is struggling to recover from the economic hard times that followed the violent Palestinian uprising against Israel that broke out in late 2000.
Tourists and pilgrims who were scared away by the fighting have been returning in larger numbers. Last year's Christmas Eve celebration produced the highest turnout in more than a decade, with some 100,000 visitors, including foreign workers and Arab Christians from Israel.
The Israeli Tourism Ministry predicted a 25 percent drop from that level this year, following last month's clash between Israel and Palestinian militants in Gaza, which put a chill on tourist arrivals. Foreign tourists heading to Bethlehem must pass through Israel or the Israel-controlled border crossing into the West Bank from Jordan.
Outside the town's quaint Manger Square, Bethlehem is a drab, sprawling town with a dwindling Christian base - a far cry from the pastoral village of biblical times.
About 22,000 Palestinians live in Bethlehem, according to the town council, but combined with several surrounding communities has a population of some 50,000 people.
Overall, there are only about 50,000 Christians in the West Bank, less than 3 percent of the population, the result of a lower birthrate and increased emigration. Bethlehem's Christians make up only a third of its residents, down from 75 percent a few decades ago.
Elias Joha, a 44-year-old Christian who runs a souvenir store, said even with the U.N. recognition, this year's celebrations were sad for him. He said most of his family has left, and that if he had the opportunity, he would do the same.
"These celebrations are not even for Christians because there are no Christians. It is going from bad to worse from all sides ... we are not enjoying Christmas as before."
Located on the southeastern outskirts of Jerusalem, Bethlehem has the highest unemployment in the West Bank, but the tourist boom of Christmas offered a brief reprieve. Officials say all 34 hotels in the town are fully booked for the Christmas season, including 13 new ones built this year.
Israel turned Bethlehem over to Palestinian civil control a few days before Christmas in 1995, and since then, residents have been celebrating the holiday regardless of their religion. Many Muslims took part in celebration Monday as well.
Christians across the region marked the holiday.
In Iraq, Christians gathered for services with tight security, including at Baghdad's Our Lady of Salvation church, the scene of a brutal October 2010 attack that killed more than 50 worshippers and wounded scores more.
Earlier this month, Cardinal Leonardo Sandri, who is responsible for the Vatican's outreach to the Middle East's Catholic communities, traveled to Iraq and presided over a Mass to rededicate the church following renovations. In his homily, he remembered those who were killed and expressed hope that "the tears shed in this sacred place become the good seed of communion and witness and bear much fruit," according to an account by Vatican Radio.
The exact number of Christians remaining in Iraq is not known, but it has fallen sharply from as many as 1.4 million before the U.S.-led invasion nearly a decade ago to about 400,000 to 600,000, according community leaders cited by the U.S. State Department.
In the Vatican, Pope Benedict XVI lit a Christmas peace candle set on the windowsill of his private studio.
Pilgrims, tourists and Romans gathered below in St. Peter's Square for the inauguration Monday evening of a Nativity scene and cheered when the flame was lit.
Later, the pope led Christmas Eve Mass in St. Peter's Basilica, prayed that Israelis and Palestinians live in peace and freedom, and asked the faithful to pray for strife-torn Syria as well as Lebanon and Iraq.
The ceremony began at 10 p.m. local time Monday with the blare of trumpets, meant to symbolize Christian joy over the news of Christ's birth in Bethlehem. The basilica's main bell tolled outside, and the sweet voices of the Vatican's boys' choir wafted across the packed venue.
Christmas Eve Mass at the Vatican traditionally began at midnight, but the start time was moved up years ago so as to give the 85-year-old pontiff more time to rest before his Christmas Day speech. That address is to be delivered at midday Tuesday from the basilica's central balcony.