What happens to the worlds that are within Federation Space that decline to join the UFP? How are they treated?
Answer
I think the simple answer is: They got to keep their space.
I have no official source to back this up, but if we look at the Federation, then the most plausible way to deal with worlds which are enclosed by Federation space is to give them their space.
E.g. imagine a world within Federation-Space boundaries, if that world does not want to be part of the Federation, it would most likely get a certain "private" space assigned to it and maybe further privileges (like fly-through Federation space to other stars etc.).

From there the diplomatic relations are pretty straight forward like with every other world outside their borders.
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