Hello Cutie,
One step at a time here. Firstly, as a parent, your job is to protect your child from any percievable harm. If, (I stress IF ) you genuinely feel knowing or having a relationship with any individual is not the best thing for her, it is your job to draw the line. Father or no, you're the parent right now, you're her protector, you're the decision maker. This means you need to consider whether or not you want him to have contact with her, whether he wants contact with her, and whether there is a need in your child for this connection, or merely a fantasy she's trying to flesh out with any available pallet. Everything else is fluff.
Now, that clarification aside, do I think you should tell your daughter the truth? Yes. Regardless of whether or not you allow contact. Parents seem to forget how truly intelligent and perceptive their children are (your daughter knows darn good and well something is up and is probably looking for an answer). However, it's not a question of what you say to her, it's how you say it. There's a huge difference between "Your daddy is a bad man and in prison," and "Your daddy did some bad things and is saying he's sorry the way adult people do." Simply telling your daughter her parents make mistakes is not earth shattering news. Say a curse word around her and see how quick she corrects you :). But showing her how to treat those mistakes is.
It's not an impossible task you've set yourself to Cutie, just a difficult one that requires some serious consideration. In the end, I have no doubt you will make the choice you feel is absolutely best for your daughter, come hell or high water.