Plans to build a mosque just below Nazareth's Roman Catholic Basilica of the Annunciation in 1999 stirred anger among the Christian community, which makes up 30 per cent of the city's 66,000 population.
An estimated 130,000 of Israel's 7.4 million residents are Christian, while in the Palestinian territories the ratio is 50,000 of a total population of 3.8 million.
Benedict held mass in an open amphitheatre on Mount Precipice, revered by Christians as the place where Jesus vanished as a crowd angered by his teachings tried to throw him off a cliff.
Al Jazeera's Sherine Tadros, reporting from the scene, said about 50,000 people had gathered to listen to the pontiff.
"There's a real sense of excitement and pride here as the ground mass gets under way.
"This is the largest Arab city in Israel so it's a great source of pride that the biggest mass of the papal pilgrimage is taking place here.
"We should also remember those Palestinians in the the West Bank and Gaza that haven't been allowed to leave the occupied territories because the Israeli authorities have not given out enough permits for them to attend this mass.
"For them, the mass might as well be taking place millions of miles away."
After the mass, Benedict met Binyamin Netanyahu, the Israeli right-wing prime minister, for talks at a church in Nazareth.
Officials did not immediately release details of the closed-door meeting.
Benedict has already held talks with Mahmoud Abbas, the Palestinian president, in Bethlehem on Wednesday, where he called for a sovereign Palestinian homeland, lamented Israel's "tragic" separation wall and appealed for an end to the Gaza blockade.
Our correspondent said there had not been much Israeli reaction to his speech, neither from the foreign ministry nor the Israeli papers.
"The main Israeli paper this morning totally ignored those comments made by the pontiff," she said.
"We did speak to someone in the foreign ministry who said there was no official statement but they felt the Holy See was very much balanced in its speech.
"[The pope] talked about the need to take down the separation wall but the Holy See also reiterated the idea of the Palestinians having to resist the temptation of violence."