Translation:This is a small town, there is no police station or prison here.
Other than from the context, why would "city" be an incorrect translation, rather than town?
So, I don't get it - when do you merge kis with the following word and when do you not? There was another sentence that had kisfiú but apparently kisváros isn't correct.
I guess you split it when you want to emphasize the "small" part only. "This is a SMALL town, as opposed to large towns.
The same thing happens with preverbs and their verbs. Sometimes you want to stress only the preverb part:
Idejövök - I come here.
IDE jövök, nem oda. - I come HERE, not there.
Also, sometimes the "kis" is kind of part of the meaning of the word. For example:
Kisbaba - baby. Literally, a small baby. But it is more of an endearing factor there. Babies are small anyway.
Kis baba - a small baby. A baby that is small (compared to other babies).
The same concept can also be at work with "kisváros". A "kisváros" is a category. A "small town", with a small town feeling. There could be smaller and larger "small towns".