In Bethlehem's Manger Square a Palestinian student choir sang and a visiting Korean pop band played to briefly lift spirits on another bleak Christmas for the town of Jesus's birth now encircled by Israeli forces.

Top aides to Palestinian Prime Minister Ahmed Qurie and Israeli counterpart Ariel Sharon had been expected to meet in Jerusalem in continuing efforts to arrange a summit and revive a US-led peace "road map" battered by a resurgence of violence.

"The meeting has been put off in protest at Israel's killing of Palestinians in Rafah," a Palestinian political source told Reuters, referring to Tuesday's tank and bulldozer incursion into a Gaza Strip refugee camp on the border with Egypt.

Israeli officials could not be reached for comment.

Israeli troops left Rafah on Wednesday after some of the fiercest clashes in two months. The army said it had uncovered an arms smuggling tunnel. Palestinian medics identified the dead as five militants, a policeman, and three bystanders.

The bloodshed again highlighted the failure of either side to push ahead with the road map, which has confidence-building steps meant to pave the way to a Palestinian state by 2005.

In Manger Square, lights twinkled festively from a towering Christmas tree and hundreds gathered to students singing carols and Koreans playing pop tunes with dancers alongside.

But the festivities, followed by midnight Mass in the ancient Church of the Nativity built over the spot where Jesus was said to have been born, were a far cry from the thousands of pilgrims who would have once packed Bethlehem for Christmas.

Israel said it had eased travel restrictions in the West Bank to allow pilgrims to reach Bethlehem for Christmas.

After the Rafah raid, Palestinian militants vowed renewed suicide bombings in Israel.

Israel demands a Palestinian crackdown on militants as required by the road map, and has said that if the plan fails it will take unilateral steps that could cost Palestinians some of the territory they want for a state in the West Bank and Gaza.