Normally dnsmasq will send a default route (the address of the host in
the network definition) to any client requesting an address via
DHCP. On an isolated network this makes no sense, as we have iptables
to prevent any traffic going out via that interface, so anything sent
that way would be dropped anyway.

This extra/unusable default route becomes problematic if you have
setup a guest with multiple network interfaces, with one connected to
an isolated network and another that provides connectivity to the
outside (example - one interface directly connecting to a physical
interface via macvtap, with a second connected to an isolated network
so that the host and guest can communicate (macvtap doesn't support
guest<->host communication without an external switch that supports
vepa, or reflecting all traffic back)). In this case, if the guest
chooses the default route of the isolated network, the guest will not
be able to get network traffic beyond the host.

To prevent dnsmasq from sending a default route, you can tell it to
send 0 bytes of data for the default route option (option number 3)
with --dhcp-option=3 (normally the data to send for the option would
follow the option number; no extra data means "don't send this option").

I have checked on RHEL5 (a good representative of the oldest supported
libvirt platforms) and its version of dnsmasq (2.45) does support
--dhcp-option, so this shouldn't create any compatibility problems.