Is it possible the city was a Minor Faction?  I've captured Empire/Kingdom cities and been able to level them up.  But when I captured a Minor Factions city, I was unable to.  I saw the same information you are describing. 

In these new versions, a Minor Factions city functions more as a fort than a city.  You can heal, train, garrison, and equip units in them.  You can also build stuff, but you can't grow the population.  And they get no influence border.  They don't have their special resource anymore either.  I'm not sure how I view this change yet.  Will need to play more.  It is kind of cool to see a quasi Fort in game.  I'd like to actually be able to build forts in the future.  This minor faction mechanic would work sans the buildings.

I think I agree Mals.  At the very least though, they provide a forward operating base for the healing and equipping of adventuring units.  Can also train units to reinforce the heroes in their questing.  Is useful when adventuring far from the home land.  But the gear they provide as a trading partener makes for good reason to let them live... for a time.