When you friend someone and they show up in your friends, you can then set the city level.
I am not sure if it is a quirk, but I had to do it on my phone and on the web based latitude - could be an early bug?
On the web, you need to look at your friends then click the profile link for the friend then you can change the setting. Should then have a little group of buildings next to the friend representing city access.
On the iPhone client you select the friend, then click the blue arrow on the right, then set the "privacy" settings.
Gotcha, thanks