Some people wept as Bishop Belo said this was not only a time for celebration but for remembrance for those killed during 24 years of repressive Indonesian rule.
But amid the celebrations, the United Nations has warned that pro-Indonesian militias are stepping up their campaign of violence, and questioned whether the Indonesian army is acting to prevent them.
The crowd outside doubled the congregation of 1,500 inside, among whom were nuns, UN officials and independence leader Xanana Gusmao.
Many arrived in their Sunday best, singing and carrying flowers.
Some people wept as Bishop Belo said this was not only a time for celebration but for remembrance for those killed during 24 years of repressive Indonesian rule.
It is believed that some 1,000 people were killed by pro-Jakarta militia in the wake of last year's independence referendum.
"This suffering will help East Timorese to become stronger," he said, speaking both in Portuguese and in the local Tetum dialect.
'This day is yours'
Mr Gusmao also addressed the crowd, which cheered and clapped as he began speaking.
"You might shout because you are crying. You might tell the world because you are suffering. But this day is yours. Our people's day," he said.
"In each house I know that people are also crying because within this atmosphere of freedom, a lot of people have lost. Lost their belongings and everything."
During the day it was announced that Mr Gusmao had overwhelmingly been re-elected president of the main political organisation set up to resist Indonesian rule, the National Resistance Council of East Timor.
The other well known independence leader, Jose Ramos Horta, was also confirmed in his position as one of the vice-presidents by a council congress.
Last Sunday the two men threatened to leave their posts in what our correspondent says appeared to have been a tactic to forge greater unity within the organisation.
UN warning
As celebrations got under way in Dili, the UN said that around 2,000 pro-Indonesian militia members had demonstrated outside their offices in the provincial capital of neighbouring West Timor, Kupang.
At the UN in New York, a senior official warned that the militias might launch "guerrilla-style operations" to disrupt the UN operation and attack civilians.
Hedi Annabi, assistant secretary-general for peacekeeping, said that recent events raised "serious concern" about the Indonesian's army ability and will to crack down on the militias.
The BBC's Richard Galpin in Dili says that despite the trauma of the violence last year, there is now considerable optimism amongst the people of East Timor.
He says that they believe they do have a positive future before them, even if it will take many years to create a fully independent nation.