Hello!
Here is what I think is wrong:
Set Smooth would not change your image at all unless your using Indigo version 0.7 test 5 and a Blender 07 exporter (I say latest test because I think it is the one you should use, since bugs have been fixed along the test versions etc 1 2 3 4) where the normal smoothing tags were used. Also just setting normal smoothing to true in the xml will not do anything either. Pushing the button in Blender alters the mesh data exported by the exporter. That is why you need to both push the button and make sure your using indigo 07 test 5. The 07t5 Blender exporter I updated will use the smoothing if you click the set smooth button. I'm not sure how this is handled by the exporter Zuegs is working on.
This smoothing allows you to have a low quality sphere where you render it in Indigo the reflections on it will be very smooth. The geometry of this sphere will still be square-ish around the edges depending on your camera angle.
Subsurfing increases the data of the mesh and as you probably saw makes the mesh really big really fast. This makes for a big big xml file. And still leaves for a square-ish appearance in the reflection although they will get smaller and smaller the more you subsurf it. (likely why your spheres are starting to look like jaggies, its not aliasing but the geometry of the sphere, made up of little squares)
I imagine if you were using Indigo 07 and a Blender 07 exporter this same scene like you show above could be in an xml less than a MB size. The sphere could be primitives or set smoothed and they would look flawless. They could even be instanced.
And also .sphere to mesh name will not use any primitives unless your using exporters with this feature. The 07t5 exporter I work on uses these now and I think the one Zuegs is working on does too.
So in order to help we need to know what version of Indigo and what version of the Blender exporter you are using.
You said Indigo 06 and I think you are stuck with that result because normal smoothing was not in Indigo yet. And I do not think any Blender 06 exporters had primitives either. (Unless U3dreal included primitives in the 06 exporter, I don't remember and I never used it?)
You could always hand edit the xml file and put primitives in yourself, I suppose...
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