I shall sum up:
Combat-multiplying Armies are for the purpose of centering combat around these 'units.' It is meant to simulate the 'realistic' effect of plaqcing your forces into large, organized groups as opposed to scattering them all over the map. Although you would still be able to scatter units all over the map, they wouldn't be able to put up much of a fight against an attacking Army. As things are now, one blockading unit can do enough damage to an attacking Army that the Army will have to stop and heal before pushing on and that makes Armies highly ineffective (i.e. 1 unit should logically be paste if going up against a whole Army --all the 1 unit can hope to do is to do as much damage as possibe before being destroyed). Armies are designed for conquest and not to just to give a slight advantage to the individual units loaded into it.
Using the combat-multiplying effect, the idea is that if an Army appears on your borders, and you are unprepared, the best strategy is to pull back and let the Army take one or two cities (since the lone units in the area will be unlikely to put up a big fight) only to regroup, bring other units to the front line and hold the enemy Army until you can get your own Army/Armies to the area and kick the enemy Army's ass. If you don't have any Armies, you resort to surrounding the Army moving your individual units in such a way that they can attack first (usually using fast units which have a tendency to havce a better attack). You will gradually wear down the Army until it either has to retreat or be destroyed. For those of you who don't like the idea of marauding Armies
As for the comment about this degrading the usfulness of "Steal Military Plans," I should say that the opposite would be true. If you steal plans, you know where all the enemy's units are which is good, but if you steal plans and you find out that the enemy has a massive Army coming your way, knowing where the enemy's units are could mean the difference between losing (only if you're dumb enough to keep your unit numbers low, knowing full well that your neighbour is an imperialist --are you hearing this Canada?). Keeping your Armies updated (note to Firaxis: units in Army must be updateable and unloadable) would be a must.
A powerful Army (or multiple Armies) crossing your borders is far more of a threat than just a bunch of units that you can pick off individually. And, assuming it could handle building Armies, this would make the AI a more formidable player during times of war.
As for limiting the number of units that a city can hold, the main reason is that it prevents a civ from placing all its units into a single city; i.e. 100 units into a Town of 1 (that would be like putting multiple millions of troops into a small town of 10 000). Now, in reality (there it is again), you could technically fit millions of troops into a city, the problem is that you wouldn find it very difficult to feed them all --not to mention a tone of other logistical problems. Civ3 is nowhere near that complex so we just say it can't be done and that's that.
Limiting the number based on the number of Citizens seems logical enough as Citizens represent the city's physical size. Bigger cities should be centers of defense --crucial targets for the enemy.
Note: Civ2 (and Civ 1) gave the incentive to defend large cities because if you didn't, all units with that home city would disband.
From the gameplay point of view, limiting the number of units per city essentially (as has been said) keeps the battles 'in the open;' i.e. a certain number of units can't stay in cities so war ceases to be highly defensive (units get defense bonus from cities and attack any units with weak defense the come near) and becomes more battle-oriented (units are forced to go out and meet the enemy --like it should be. In other words, it keeps combat mobile, and in games more activity is a good thing.
'Total War' has an effect similar to this: a limited number of units can garrison a province and withstand a siege from the safety of a castle while the rest of the unlucky bastards have to go and engage the enemy or flee to another province.
That said, there is another problem (although it's minor) with limiting units in cities: what happens when you build units in a city that is 'full up?' I guess the simplest solution would be to just have the city hold off production of the unit until a unit has been removed and you get a pop-up saying something like: "You have too many units in this city. you will have to remove some for more to be built."
The only other problem (although it's only a problem if you don't like it) is that you can only heal a limited number of units in a city --they have to be removed and replaced with other damaged units. Personally I like that because it keeps players from just healing all their units at one time which then puts the attacker at an extreme disadvantage since all his units are damaged. Just for the record, I'm not saying that attackers shouldn't be at a disadvantage (vs cities at least), but rather that the disadvantage is a little too unbalancing.
As for the obvious problem of bombardment lowering population but not necessarily destroying the garrisoning units, one should assume that there is still enough 'room'...even if it's just ruins.
Just to keep with the topic of the thread, I think A/D-multiplying Armies would reduce the effects random combat outcomes as even the 'luckiest' individual unit won't stand much of a chance against an Army --whereas they do as things are now.
As for the comment about limiting units in cities making the combat less 'surprising,' all I can say is that any good leader/general will never go into a situation where he knows nothing about what to expect --only the bad ones do that, and most have come to a sticky end because of it. If you want more unexpected consequenses then add in features like giving double attack to units attacking from Forest squares and making them invisible while on those squares thus allowing for the possibility of surprise attacks. Conventional attacks should be highly gaugeable.
Another way of making differences that cannot be reproduced is to give Armies the ability to give give combat bonuses to their units and to give the GL experience that increases this bonus (I also mentioned this before).
Tell me again why none of this makes the game more strategic but makes it easier?