What a Toughy! ;]
I think that cluttering up the navigation with a ton of tabs for cities won't make your user experience thrive, nor will it benefit you at all on the SEO side of things.
You're best bet would be to go with your second choice. Create a single link in the navigation for 'Service'. Then on the 'Service' page, create a dropdown which includes your cities.
As far as redirecting/rewriting the URLs from linking goes, for the most part, you CAN do that using your HTACCESS file, and RewriteRule. However, I wouldn't recommend it. It doesn't give you any added benefit.