A method of manufacture of an integrated circuit packaging system includes: providing a substrate; attaching an integrated circuit to the substrate; molding an encapsulation directly on the integrated circuit and the substrate; forming a trench in the encapsulation having a trench bottom surface and surrounding the integrated circuit; and mounting a heatsink having a heatsink rim over the integrated circuit with the heatsink rim within the trench and the heatsink electrically isolated from the substrate.