Speaking at Midnight Mass at the Church of the Nativity in Bethlehem, Latin Patriarch Michel Sabbah called on Israel to "alter its vision".
Christmas Day itself in Bethlehem was a sombre occasion, with rain adding to the gloom.
"
Blood has been flowing in your cities and streets but the key to solving this conflict is in your hands
"
Latin Patriarch
Michel Sabbah
"It is the saddest Christmas ever for us here," Estella Mubarak, a 60-year-old grandmother, told the Reuters news agency at the Church of the Nativity, built on the spot where Christians believe Jesus was born.
There were no reports of violence in the town, which Israeli troops have occupied since a suicide bomber believed to have come from Bethlehem killed 11 people in November.
They withdrew to the outskirts of Bethlehem for the Christmas holiday.
Little cheer
The BBC's James Reynolds reports that although the church was full for midnight Mass, the non-religious trappings of the festive season were largely absent from Bethlehem.
Palestinian leader Yasser Arafat was banned from attending the mass. An empty chair indicated where he would have sat.
"It is not impossible for the faithful to feel love for all our brothers, whether they be Muslims, Christian, Jews or Druze," the patriarch, himself a Palestinian, said.
Then, addressing Israel itself, he added:
"Blood has been flowing in your cities and streets but the key to solving this conflict is in your hands.
"By your actions so far, you have crushed the Palestinian people but you still have not achieved peace."
He also told Palestinians: "What is required is the stopping of violence and terrorism".
The Patriarch also addressed Mr Arafat's empty seat, which was draped with his distinctive chequered Arab headdress, wishing him "the wisdom and the power under this siege to continue your mission toward peace and justice".
'Christmas under fire'
Our correspondent says that Israeli forces, who have occupied the town for much of the year, agreed to stay away from Bethlehem's centre for two days.
But, he adds, they will be back and the town will be under curfew once more.
This year Manger Square is lit up by headlights rather than a twinkling Christmas tree, as cars and taxis are using it as a parking spot.
The town's Palestinian mayor, Hanna Nasser, said the fairy lights had been switched off in protest at the Israeli occupation.
Gone, too, are the thousands of pilgrims who packed the town for Christmas Eve celebrations before the second Palestinian intifada, or uprising, began in September 2000.
Israel has banned Mr Arafat from attending Christmas services in the town for the second consecutive year, accusing him of failing to prevent attacks against Israelis.
BETHLEHEM'S HISTORY
The veteran Palestinian sent Christmas greetings from his headquarters in the West Bank city of Ramallah.
The Israeli Government said it would organise buses to take Christians from the West Bank, the Gaza Strip and Israel to Christmas services.
"Anyone who wants to go to Bethlehem will have a seat," said government spokesman Ranaan Gissin.
"One cannot ignore that this is not an ordinary Christmas, this is Christmas under fire," he added.
The army lifted the curfew in Bethlehem on Sunday and said it would not re-impose it unless there was an alert.
Fresh violence
Violence continued through Christmas, with Israeli soldiers killing a member of the militant group Hamas in the West Bank town of Nablus.
A teenage Palestinian boy was killed and three others were wounded in the Gaza Strip on Tuesday when Israeli tanks fired a shell into a group between the Karni and Erez crossings with Israel.