Tens of thousands of Christians, among them many Arabs, attended the service in the north Israeli town of Nazareth, where Jesus is said to have grown up.
Benedict later met Israeli PM Benjamin Netanyahu, a day after vocally backing the idea a Palestinian homeland.
Mr Netanyahu does not support the idea of an independent Palestinian state.
The German-born Pope's visit to Israel and the Palestinian territories has sparked criticism from Jewish groups who say he did not condemn Nazi crimes strongly enough.
While he condemned anti-Semitism at the outset of his visit, and made a strong attack on Holocaust deniers at in his speech at the Yad Vashem Holocaust memorial, he did not directly address the issue of the Catholic Church's silence during the Holocaust.
Some also expected him to talk again about his enrolment, like millions of other German children, into the Hitler Youth during the Nazi era.
Appeal for peace HAVE YOUR SAY His visit will make zero difference - it's simply putting more religion into the middle east and what it needs is secularism. Peter Moseley, Bangkok
Crowds waved flags to greet the pontiff as he arrived in his white popemobile in Nazareth, a predominantly Israeli-Arab town.
A 40,000-seat amphitheatre was built specially for the event at Mount Precipice, where the Bible holds that an angry mob tried to hurl Jesus off a cliff.
Christians make up about a third of the town's Arab population, which is otherwise Muslim, and there has on occasion been friction between the two communities.
In his homily, Benedict spoke of tensions that have harmed interfaith relations.
"I urge people of goodwill in both communities to repair the damage that has been done, and in fidelity to our common belief in one God, the father of the human family, to work to build bridges and find the way to a peaceful coexistence," he said.
"Let everyone reject the destructive power of hatred and prejudice, which kills men's souls before it kills their bodies."
Pope Benedict is later began talks with Mr Netanyahu near the Church of the Annunciation, said to mark the spot where the Angel Gabriel told the Virgin Mary she would give birth to Jesus.
On Wednesday, the Pope visited a refugee camp in Bethlehem in the shadow of a concrete section of Israel's West Bank barrier.
Call for homeland
In Bethlehem, he delivered what correspondents say was one of his strongest expressions of support for the Palestinians, offering his backing for Palestinians' right to a "homeland".
The Pope called the barrier a symbol of "stalemate" between Israel and the Palestinians.
He told the refugees that his heart went out to families divided by detention and restrictions on freedom of movement, a reference to Israeli military control of the West Bank.
"It is understandable that you often feel frustrated. Your legitimate aspirations for permanent homes, for an independent Palestinian state, remain unfulfilled."
Earlier he said he prayed for a lifting of Israel's embargo on Gaza, but also urged Palestinians to resist the "temptation" to resort to violence.
One of the aims of the pontiff's visit is to preserve a diminishing Christian presence in the Holy Land.
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