Israel's incursions began after Zeevi's assassination
Palestinian security officials said the withdrawal had begun with six Israeli tanks pulling out of the northern and southern entrances to the town.
The army said its forces had pulled back a few hundred metres to the edge of the Palestinian-controlled territory and into Israel.
The withdrawal went ahead despite an attack by a Palestinian gunman in Jerusalem, in which two teenagers were killed and about 50 people injured.
Israel has been under intense pressure from its key ally, the US, to pull out of the West Bank towns, for fear that heightened tension in the area could jeopardise the American-led coalition against international terrorism.
Israeli forces last week pulled out of Bethlehem and nearby Beit Jala, two other towns they occupied after the assassination of tourism minister Rehavam Zeevi.
Ongoing violence
Two Palestinians were wounded in a shootout with Israeli troops in the Palestinian-controlled town of Rafah in the Gaza Strip on Monday.
The clash came after Israeli forces demolished two buildings in the area, Israel Radio reported.
In Sunday's attack in Jerusalem, a Palestinian gunman opened fire on a bus at the French Hill junction in the north of the city.
A border police officer and a soldier shot and killed the gunman, Jerusalem police chief Mickey Levy told Israel radio.
Mr Levy identified the attacker as a member of the militant group Islamic Jihad, from the West Bank town of Hebron.
A 16-year-old girl and a 14-year-old boy who were on the bus were killed. Four other people were seriously injured.
In a statement, the Palestinian Authority "strongly" condemned the shooting and vowed to bring the guilty parties to justice.
But the statement also blamed Israel for "the deterioration of the situation... due to its continuing occupation of Palestinian autonomous areas and its policy of assassinating Palestinians."
Israeli sources have told the BBC there is no timetable to leave the remaining three towns of Ramallah, Tulkarm and Jenin.
Diplomatic pressure
The United States has been pushing Israel to resume talks with the Palestinians and pull out of the towns it has occupied in the West Bank.
Israeli Prime Minister Ariel Sharon has said his forces will only withdraw when the Palestinian Authority has outlawed militant groups and handed over those responsible for Mr Zeevi's assassination.
Arab League Secretary-General Amr Moussa added to calls for progress on a Middle East settlement on Sunday.
Speaking before a meeting with 10 Arab foreign ministers, he said a new peace deal between Israel and the Palestinians must have as one of its aims the establishment of a Palestinian state.