The game will enter an entirely new area, where you must spend, in real time, all of your jail sentence. There is no fast forwarding, even while sleeping. A year sentence is a whole year you must live in the jail. Shank people, get shanked, smuggle goods in your naughty place, harass the guards, and all sorts of criminal fun in Skyrim's devilish dungeons!
I like this idea, but on a much smaller and shorter scale. I wouldnt mind going to jail for a certain period of time in game. Not only is it a new area to explore and there are lots of things you could do with it, its also a lot better of a punishment than the screen just loading to the end of your sentence.
There could be a few things you do there....
Play prison games.
Barter contraband.
Do prison work.
Learn (books, classes)
Fight.
ESCAPE!
As long as it wasnt too long then it would be fun. And as long as the option to escape was always there, albeit hard to do.