Pope Benedict XVI was later due to appear at the window of his apartments overlooking the square to light a candle for peace, before celebrating mass.
As day broke on the not-so-little-town of Bethlehem, just a few miles south of Jerusalem, locals prepared to welcome thousands of pilgrims who wanted to see the spot where the Bible says Jesus was born to a couple from Nazareth.
The Latin Patriarch of Jerusalem Fuad Twal, the most senior Roman Catholic bishop in the Middle East, made his solemn entry into the birthplace of Christ in the middle of the afternoon.
He was accompanied by Palestinian Scouts playing bagpipes, an inheritance from the British mandate in the first half of the 20th century.
The colourful procession led to Manger Square in the centre of Bethlehem, where a huge poster at Omar's Mosque showed Palestinian president Mahmud Abbas and late Palestinian leader Yasser Arafat.
Christmas is a national holiday in the Palestinian territories.
Hotels and guest houses across this ancient town perched on the hilltops were packed to capacity, Palestinian officials said, with more than 50,000 visitors from around the world expected to join in the festivities.
"Hotels are full. We have no rooms left even though the number of hotel rooms has multiplied in the last three years," Palestinian tourism minister Khulud Daibes told AFP.
Christmas Eve celebrations are all taking place in and around Manger Square, the central plaza next to the Church of the Nativity. The church is built over the site where Christians believe Mary gave birth to Jesus in a stable, and laid him in an animal's feeding trough, or manger.
The boy scouts, with their drums and bagpipes, marched through the town during the afternoon for the annual Christmas parade, after which concerts and other entertainment got underway on what is the biggest tourist attraction of the year in the Palestinian territories.
A huge Christmas tree covered in lights and glittering decorations dominated the centre of the square, which was already filling up with excited visitors, some wearing red Santa hats, others in the sombre garb of various monastic orders.
Singing filled the square as pilgrims belted out carols in Arabic, and street vendors carried out a brisk trade in cakes, sweets and hot air balloons.
"This is my first time here. It's very surreal," said Josh, a American in his 20s from Arkansas who was wearing a traditional Palestinian keffiyeh scarf.
"Being here in the Holy Land where Jesus is from is great!"
Excited tourists snapped pictures of the giant tree and of a local dressed up as Father Christmas, as a group of foreign activists in Santa hats, each wearing a letter on their clothes, lined up to spell the words: Free Palestine.
There were also Muslims among the crowds. Many veiled women brought their children to join the celebrations over the birth of Jesus, or Isa in Arabic, whom they revere as a prophet.
"I'm here today to see the celebrations like every year. We come as Christians and Muslims to see them," said Shireen Knaan. "There is no difference between Christians and Muslims as it is the Prophet Isa's birthday."
The celebrations were to continue into the night and culminate with a celebration of midnight mass by Twal.
The mass is traditionally attended by top officials from the Palestinian Authority including Abbas and prime minister Salam Fayyad.
Twal is expected to deliver a message of hope for peace in the Middle East and around the world, which was also expected to touch on the revolutions sweeping the Arab world.
In a message delivered earlier this week, Twal acknowledged feeling "a little anxious and concerned" about the ongoing turmoil in the Arab world.
"I have always defended the changes taking place in favour of freedom and democracy. I have repeatedly emphasised that Christians are not excluded from these movements," he said.
Twal urged the ruling authorities to "make every effort to calm the spirits, without violence," demanding they "grasp this moment of opportunity to build a new society based on equal citizenship for all."
He also called for a "just and comprehensive peace" to end the Israeli-Palestinian conflict.
Bethlehem attracts hundreds of thousands of pilgrims each year and is the main tourist attraction in the Palestinian territories.
The Israeli army has eased security measures to facilitate the arrival in Bethlehem of Palestinian and Arab Israeli Christians.
The town is cut off from neighbouring Israel by part of the separation barrier that snakes along, and often inside, the line dividing Israel from the West Bank.
Roman Catholics, Protestants and some Eastern Orthodox celebrate Christmas on December 25, but other Orthodox and oriental churches do not do so until January.
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