Offhand, I think the idea would be to limit free sprawl, but allow for large, developed sprawl. Namely, your large core cities need to have buildings/produce resources that fuel your continued outward expansion. Currently, that is not the case because you can deal with the happiness constraint without needing to develop your core significantly. So, the happiness mechanic needs some revision, obviously.
This would be the "oh god I live in a





hole" penalty.
Simple enough to implement. Along with the unhappy generated by pop and cities, you would add.

= 2(C^2)/p.
C is the number of cities settled after your capital (conquered cities are excluded, but not their population, even if they have courthouses) while P is your total population (excluding puppets).
The idea is that, starting out, this wouldn't affect you particularly badly.
Your capital would obviously excluded.
Your second city wouldn't impact that greatly because your population would level the penalty out entirely.
In fact, it only starts to impact once you start building a silly number of small population cities, or when 2(c^2) starts becoming larger than your total population.
And this would actually encourage players not to burn cities they take and seek to annexe them.
So for an empire that's balanced in terms of its population:
100 pop over ten cities: would be a penalty of 1 extra unhappy. I.e. not a big deal.
100 pop over 25 cities: would be a penalty of 12 extra unhappy.
I don't think you could make the penalty greater without breaking the game in the other direction.
For the indians, you would have to change things slightly: 4C^2/(pop/2)
Other things to balance the game;
Cities cannot be traded in lieu of peace. (stops the AI from being ********).
You would have to add a research penalty should you become unhappy.
Make theatres and stadia more effective: produce more

but for the same price they currently are: but Colleseums slightly less effective (+3

instead of 4.
So theatres could give you 5
Stadiums could give you 7
This would make building larger cities worthwhile.
And on the extreme end: prevent cities being built closer than four tiles apart (reduces the defensive viability of ICS).
I personally wouldn't wish to discourage ICS entirely: it's an option if you find yourself on an isoalted start: and as stated in a previous thread, it doesn't always gaurantee victory.
ICS can also make it more difficult to obtain social policies.
Besides, if you run your empire effectively why should you be penalised just for having a large number of cities? Why should horizontal expansion be so difficult as to be absolutely prohibited?
What I would hope to discourage through this is the negative play that often characterizes a sucessful strategy on civ V. (razing other civs cities etc).