Call for understanding
The pope said that "great courage" is required in order to bring mutual mistrust between Israel and the Palestinians to an end.
"There has to be a willingness to take bold and imaginative initiatives towards reconciliation," he said.
"If each insists on prior concessions from the other, the result can only be stalemate."
The pope said he understood the frustration felt by Palestinian refugees.
"Your legitimate aspirations for permanent homes, for an independent Palestinian state remain unfulfilled.
"Instead you find yourselves trapped ... in a spiral of violence, of attack and counter-attack, retaliation and continual destruction. The whole world is longing for this spiral to be broken, for peace to put an end to the constant fighting."
'Right to homeland'
The pontiff earlier told Palestinians in Bethlehem's Manger Square that he believes they have the right to a sovereign Palestinian homeland.
"Mr President, the Holy See supports the right of your people to a sovereign Palestinian homeland in the land of your forefathers, secure and at peace with its neighbours, within internationally recognised borders," the pope said.
He called on the Palestinians to resist any temptation to resort to acts of violence in what is being seen as his strongest public support yet for Palestinian statehood.
"I make this appeal to the many young people throughout the Palestinian territories today," he said.
"Do not allow the loss of life and the destruction that you have witnessed to arouse bitterness or resentment in your hearts."
'Plight' of refugees
Nour Odeh, Al Jazeera's correspondent reporting from the West Bank, said the pope's visit to Bethlehem and his drive by the Israeli separation wall was very significant to many Palestinians.
"The fact that he recognized that wall by its name and said that it was unfortunate to see these walls being erected at a time when boundaries were being eliminated, was certainly a very welcome comment by the pope."
She said many Palestinians wanted the pope to speak to their "plight as a people".
"What [they] wanted was a recognition of their plight as refugees wanting to return to their homes that they were expelled from in 1948, in line with international law.
"They got a lot of what they wanted, but not as clear as they would have hoped for, but certainly much better than was expected earlier."
Ismail Haniya, the Palestinian leader of the political faction Hamas, had called on the pope to visit Gaza to see what he described as "the real holocaust against the Palestinian people".
In 2008, Israel launched a three-week assault on the occupied Gaza Strip, killing more than 1,300 people and destroying much of the impoverished area's infrastructure.
Gaza, however, is not on the itinerary for the pope's week-long pilgrimage to the region.