Israel says the fire broke out by accident
Spokesman Joaquin Navarro-Valls said the Vatican was following events "with extreme apprehension" and trying to establish the truth about the fighting that flared early on Monday.
Israel says its troops are under orders not to fire at holy places and blamed Palestinian militants for a fire near the church, which is revered by Christians as the birthplace of Jesus Christ.
Several hundred Palestinian gunmen and civilians fleeing Israeli tanks have been holed up in the church complex for nearly a week, along with a group of monks and nuns.
A spokesman for Catholic monks in the Holy Land said earlier that Israeli soldiers were guilty of an "indescribable act of barbarity".
Israel had broken its international obligations and risked "long-term and incalculable" consequences, Father David Jaeger said.
Speaking from Rome, he said monks at the church had reported damage to "sacred spaces" and evidence that Israeli troops had entered the church.
The Pope, who has urged people to pray for peace in the Middle East, on Monday described the violence in the Holy Land as having reached "unimaginable and intolerable" levels.
Click here for a guide to the Church of the Nativity
The Israeli army says Palestinian gunmen provoked a fire which broke out near the Church of the Nativity on Monday.
Gunmen had opened fire from a belltower, wounding two Israeli border policemen in a nearby rooftop look-out, an army officer told Reuters news agency.
He said the Israelis returned fire and a smoke grenade started the blaze in a second-floor meeting hall overlooking the Basilica of St Catherine, adjacent to the Church of the Nativity.
One Palestinian gunman was shot dead in the battle, the Israeli source said.
But a priest inside the church, Father Amjad Sabbara, told the BBC that the Palestinian killed was a police officer who had been trying to douse the flames.
He said the blaze had burned for an hour, destroying a piano, chairs, altar cloths and ceremonial cups.
Father Sabbara estimated that there were 240 people in the church. Some were armed, he said, but they were "not using their arms".
The Mayor of Bethlehem, Hanna Nasser, told the BBC that mosaics inside the Basilica of St Catherine had been "affected by the bullets".
Staying put
The Israeli army has been conducting a major military operation across the West Bank for over a week, in response to a wave of suicide bombings by Palestinian militants.
"It really involves going through the cities and refugee camps and taking out the infrastructure of the terrorists: weapons, documents, explosive material, laboratories," army spokesman Captain Jacob Dalal told the BBC.
Israeli troops have been using loudspeakers to demand the surrender of the Palestinians inside the Nativity complex.
Prime Minister Ariel Sharon said on Monday that his soldiers would not "defile the holiness of the site as the [Palestinians] have" but added that the troops would remain in place until the gunmen inside were captured.
In Britain, Foreign Office Minister Ben Bradshaw described Israeli actions in the area as "totally unacceptable".
The Vatican is reported to be working out an agreement with the Israelis on safe passage for the Palestinians inside the church to the Gaza Strip.