The main reason is that Bismarck was concerned about the reactions a harsh peace would have on the rest of Europe. There is also a prelude to this.

In the prussian-austrian war of 1866, the prussian generals and also King Wilhelm wanted to annex substantial parts of austrian territory. This was stopped by Bismarck, who wanted to keep Austria as a potential ally in the future and who also feared a possible french intervention. Bismarck had to threaten with his resignation, and only was able to convince the King after the Crown Prince sided with him.

After it became clear that Germany was going to win the war against France, a similar discussion started. Again, Bismarck wanted to keep the war short and was wary of an intervention by Russia and Great Britain. However, as national sentiment was high and at least parts of Alsace and Lorraine were (and are) german-speaking, he was forced to pursue this claim and also support it in public (he did oppose military plans for further annexations, which would have left France as a puppet state).

The conditions imposed on France were therefore a compromise between the desire to end the war quick and without an intervention by Russia and France and the wish to placate the nationalist sentiment. Therefore, France was forced to cede territory - which would poison the relations until the first world war - but was left in a position to regain its power relatively quick.

The musings about the german strategy and demands are covered in quite some detail in Bismarck's autobiography (Gedanken und Erinnerungen). While this is obviously a biased source, it does offer insights into the actions of the major actors on the german side.