Does anything happen If I choose this? Do I get any special rewards, such as my own city?
At that point in the game you have your own citadel at Red Mountain. If you choose the "betray and destroy Dagoth Ur" option, you become the head of House Dagoth so basically all of the Red Mountain region could be turned into your city if you want. Dagoth Ur is gone and the Heart remains (Warning: your character has to be very very very intelligent to pull this off. And I do mean your character, not you). The entire Red Mountain region is yours to do with as you see fit. But a "ready made city" is not included. Here is where imagination comes into it.
Actually that is how it is in my game, only the difference is my character is entirely on Dagoth Ur's side and they co-rule Morrowind together. The Red Mountain region and the city I am gradually building there is their capital.