An Israeli military source confirmed the rare gunfight on Tuesday with Palestinian police, most of whom were banned by Israel from carrying weapons during the uprising that began in 2000. The source said troops were on a raid to "arrest terrorists".
Bethlehem's police commander, Issa Hejo, accused the Israelis of opening fire first near a Palestinian checkpoint, sparking gunfire that lasted several minutes and wounded one police officer.
The Israeli source said the Palestinians shot at the soldiers as they neared the local government headquarters.
"The Israeli force returned fire and fired warning shots in the air," the source said.
Bethlehem has been mostly quiet since Israelis and Palestinians agreed to a truce in February, allowing a steady increase in the number of pilgrims visiting the place revered by Christians as the birthplace of Jesus.
Israel has recently allowed Palestinian police to carry weapons in some towns. Most police were banned from bearing arms after the start of the uprising, in which lines often blurred between security forces and resistance fighters.
Bethlehem's governor said the clash was a sign that "the Israeli army doesn't care about peace in the area".