Latin Patriarch of Jerusalem Michel Sabah headed the traditional Christmas procession Tuesday afternoon in Bethlehem. The procession was attended by 3,000 people.
Earlier Tuesday, the IDF pulled back to the city's outskirts to allow Christmas celebrations to proceed in the city of Jesus's birth.
It said Christians with security permits living in Palestinian West Bank towns would be allowed into Bethlehem, as well as foreign tourists and pilgrims.
But Israel maintained its ban on Palestinian Authority Chairman Yasser Arafat, a Muslim, from making his Christmas Eve pilgrimage to Bethlehem for the second straight year. It has accused him of not doing enough to halt attacks on Israelis.
The army said troops would remain around Bethlehem's edges as they have done during much of the two-year-old Palestinian uprising for independence.
During that period, the army imposed curfews and conducted constant patrols, searching house to house and arresting dozens of suspected militants. No patrols were spotted on Tuesday morning.
Witnesses said troops had pulled back to about 200 meters from the Church of the Nativity in central Bethlehem, where local Christian dignitaries were to attend Christmas Eve mass on Tuesday night.
The army said there would be no troops in Bethlehem during Christmas week as long as intelligence information did not indicate attacks were planned against Israeli citizens. However, troops would remain around the city's edges, it said.
The announcement came a day after Palestinian leader Yasser Arafat lashed out against Israel's military grip on Bethlehem ahead of what was expected to be a muted Christmas holiday in the city.
Troops entered Bethlehem a month ago after a man from the area carried out a suicide bombing on a Jerusalem bus that killed 11 people, weeks after troops pulled back to ease conditions in Bethlehem.
Israel Radio reported Tuesday that the IDF would allow Israeli Arabs to attend Christmas services in Bethlehem, as well as West Bank Palestinians bearing special entry permits.
But Christmas Eve festivities in the West Bank city on Tuesday were expected to be short on cheer.
"Is it fair that the whole world celebrates Christmas in freedom while our people in Palestine and Bethlehem are banned from celebrating Christmas festivities?" Arafat, a Muslim, said at a meeting with Palestinian Christian leaders in the West Bank city of Ramallah on Monday.
"As the whole world adorns Christmas trees, Bethlehem...and the rest of the Palestinian cities and villages...are suffering from the darkness, siege, destruction, killing, arrests and abuses against our people at checkpoints," Arafat said.
Israel barred Arafat from Christmas events in Bethlehem for the second year running, blaming him for not stopping more than two years of bloodshed.
The Palestinian leader, who had annually attended Christmas Eve mass in the city after it was handed to Palestinian control in 1995, is now largely confined to his headquarters in Ramallah by an Israeli military siege.
Israel re-occupied every major Palestinian city and town in the West Bank, except for Jericho, in June following a wave of Palestinian suicide bombings which killed scores of Israelis.