I think to build an actual "city" you should first improve the tile with direct essense or something, and this essense helps for the immediate amount of production potential for the area, improving nearby tiles in the thin cross, for instance ... and therefore whenever you make a true "City" ... then it will have to use essense. However you can create as many villages and towns as you want, as long as you have enough physical resources and people, and as long as its established upon land which has already had regrowth visited upon it. (the life that spreads slowly outwards).
A "city" will be able to expand, grow (through immigration) and become rather powerful rather quickly, and will be the only sources of fame and prestige. You will only gain population from immigration (which seems to be the main source of pop-growth). Eventually your cities will become large metropolises, while villages are mere outposts and farming centers ... spread out among the lands to collect resources. Villages and towns can slowly grow, but only due to natural childbirth, and until you expand the village with housing and food storage, extra births will usually migrate to the city. Therefore, cities will naturally grow while you have to directly assign resources for a village to grow, and usually, other than collection of raw resources, cities will be more versatile.
If a village is in a proper location, geographically and resource speaking, you can spend essense to upgrade it into a city. I shouldn't think villages will have enough citizenry to recruit soldiers directly, although you can certainly garrison troops there if you build a fortress nearby, and you can certainly gather raw resources, occasionally housing a skilled blacksmith or alchemist for fine master-worked items, can use them for agricultural breadbaskets, and use them for limited speed equipment production (if you have built the proper facilities and have enough able men available).
Wall of Text, I know, although it would be nice to make those cities you spent essence on to be special, and for villages (which should be as numerous as your economic capabilities, and spread throughout your empire) to never quite attain the prestige or "factory potential" (production, commerce, or reasearch) of true cities.